Chinmay Hegde SFM Class Notes

CA FINAL
PAPER 2
STRATEGIC
FINANCIAL
MANAGEMENT
MATERIAL FOR CRASH COURSE
Ca CHINMAYA HEGDE
www.advaitlearning.com
9535078357
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CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE
9535078357 @cachinmayahegde 1
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Chapterwise marks distrubution
Attempts before May 2018 were Old syllabus
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Table of Contents
Chapterwise marks distrubution.............................................................................................................. 2
FINANCIAL POLICY AND CORPORATE STRATEGY ............................................. 7
1.1 Foundation principles.................................................................................................................... 8
1.2 Strategies and Framework............................................................................................................. 9
1.3 Formula basics ............................................................................................................................ 10
1.4 Summary chart ............................................................................................................................ 12
SECURITY VALUATION(BOND) .............................................................................. 15
2.1 Basics .......................................................................................................................................... 16
2.2 Valuation of bonds ...................................................................................................................... 16
2.3 Yield to maturity YTM ............................................................................................................... 17
2.4 Duration (Macaulay duration) ..................................................................................................... 18
2.5 Volatility of bond or modified duration ...................................................................................... 19
2.6 Convexity .................................................................................................................................... 19
2.7 Problems on Duration and volatility ........................................................................................... 20
2.8 Yield Curve: ................................................................................................................................ 24
2.9 Bond Replacement decision ........................................................................................................ 25
2.10 Convertible bonds ..................................................................................................................... 27
2.11 Summary chart .......................................................................................................................... 28
2.12 Problems ................................................................................................................................... 31
CORPORATE VALUATION (EQUITY) ...................................................................... 36
3.1 Basics of valuation ...................................................................................................................... 37
3.2 Dividend based valuation ............................................................................................................ 39
3.2.1 Walter Approach .................................................................................................................. 40
3.2.2 Gordon Growth Model ......................................................................................................... 40
3.2.3 Modigliani and Miller (MM) Hypothesis ............................................................................ 40
3.2.4 Dividend Discount Model .................................................................................................... 41
3.3 Free cash flow-based valuation ................................................................................................... 42
3.4 Summary chart ............................................................................................................................ 44
3.5 Problems ..................................................................................................................................... 49
SECURITY ANALYSIS ................................................................................................ 59
4.1 Basics .......................................................................................................................................... 60
4.2 Other terms.................................................................................................................................. 60
4.3 Security Analysis ........................................................................................................................ 62
4.4 Summary chart ............................................................................................................................ 65
4.5 Problems ..................................................................................................................................... 66
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PORTFOLIO MANAGEMENT..................................................................................... 69
5.1 Meanings of portfolio management ............................................................................................ 70
5.2 Basics of return and risk ............................................................................................................. 71
5.3 Markowitz portfolio theory ......................................................................................................... 74
5.4 Capital allocation line ................................................................................................................. 76
5.5 Capital Market line ..................................................................................................................... 77
5.6 Characteristic line ....................................................................................................................... 78
5.7 Beta ............................................................................................................................................. 80
5.8 Capital Asset Pricing Model or Securities Market Line ............................................................. 82
5.9 Arbitrage pricing theory .............................................................................................................. 84
5.10 Ratio parameters for selection of stocks ................................................................................... 85
5.11 Summary chart .......................................................................................................................... 86
5.12 Problems ................................................................................................................................... 96
MUTUAL FUNDS ....................................................................................................... 105
6.1 Basics of Mutual funds ............................................................................................................. 106
6.2 Summary chart .......................................................................................................................... 109
6.3 Problems ................................................................................................................................... 110
DERIVATIVES ............................................................................................................ 115
7.1 Basics of Derivatives ................................................................................................................ 116
7.2 Futures ...................................................................................................................................... 117
7.2.1 Futures for Speculation ...................................................................................................... 118
7.2.2 Fair value of future under Cost of carry model .................................................................. 118
7.2.3 Arbitrage in futures ............................................................................................................ 119
7.2.4 Hedging using Index futures .............................................................................................. 120
7.3 Options ...................................................................................................................................... 122
7.3.1 Call Options ....................................................................................................................... 122
7.3.2 Put options ......................................................................................................................... 123
7.3.3 Call option and put option summary .................................................................................. 124
7.3.4 Option strategies ................................................................................................................ 125
7.3.5 Put call parity theorem ....................................................................................................... 125
7.3.6 Option valuation................................................................................................................. 126
7.3.7 Binomial Model ................................................................................................................. 127
7.3.8 Black-scholes model .......................................................................................................... 128
7.3.9 The Greeks in option valuation .......................................................................................... 128
7.4 Summary chart .......................................................................................................................... 130
7.5 Problems ................................................................................................................................... 150
FOREIGN EXCHANGE RISK MANAGEMENT ..................................................... 160
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8.1 Basic terminologies ................................................................................................................... 161

8.2 Cross rates ................................................................................................................................. 163
8.3 Forward Market ........................................................................................................................ 164
8.4 Purchasing power parity ........................................................................................................... 166
8.5 Interest rate parity theory .......................................................................................................... 168
8.6 Foreign currency exposure hedging .......................................................................................... 170
8.6.1 Forward cover or Forward hedging ................................................................................... 171
8.6.2 Money Market Hedging ..................................................................................................... 171
8.6.3 Supplier credit Vs Bank Credit .......................................................................................... 172
8.6.4 Local borrowing Vs foreign borrowing ............................................................................. 172
8.6.5 Netting, leading and lagging .............................................................................................. 173
8.7 Forward contract disposal ......................................................................................................... 174
8.8 Currency options ....................................................................................................................... 180
8.9 Currency futures........................................................................................................................ 181
8.10 Nostro, Vostro and Loro ......................................................................................................... 184
8.11 Summary chart ........................................................................................................................ 185
8.12 Problems ................................................................................................................................. 206
INTERNATIONAL FINANCIAL MANAGEMENT .................................................. 213
9.1 Basics ........................................................................................................................................ 214
9.2 Capital budgeting under foreign exchange transactions ........................................................... 215
9.3 International working capital management ............................................................................... 215
9.4 Summary chart .......................................................................................................................... 217
9.5 Problems ................................................................................................................................... 218
INTEREST RATE MANAGEMENT ........................................................................ 221
10.1 Interest rate management basics ............................................................................................. 222
10.2 Forward rate agreements ......................................................................................................... 223
10.3 Interest rate futures ................................................................................................................. 224
10.4 Interest rate Swaps .................................................................................................................. 225
10.5 Interest rate options ................................................................................................................. 227
10.6 Summary chart ........................................................................................................................ 228
10.7 Problems ................................................................................................................................. 234
MERGERS ................................................................................................................. 236
11.1 Basics of mergers .................................................................................................................... 237
11.2 Basic Formulas........................................................................................................................ 238
11.3 Summary chart ........................................................................................................................ 239
11.4 Problems ................................................................................................................................. 241
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FINANCIAL POLICY AND CORPORATE

STRATEGY
Marks distribution
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1.1 Foundation principles

The sole objective of this subject is to make informed decisions. In the wider process of problem-
solving, decision-making involves choosing between possible solutions to a problem. Decisions can
be made through either an intuitive or reasoned process, or a combination of the two. Topics covered
here will help us making structural analysis to make decisions.
1. Historical data: Only scientific way to analyse alternatives is based on historical facts and data.
a. To summarize various past data points, concepts of average, probability is used.
b. To consider time value of money, compound interest is applied
2. Criteria for decision making: Decision making is the process of making choices by identifying
costs and benefits associated with various alternatives under consideration. In the context of
financial management, price is to be understood as cost and value to be applied as benefits. In
general, we assume cost = benefits. As defined by Warren buffet, “price is what you pay and
value is what you get “
a. Price: Amount paid to acquire a product. Price is determined by market forces i.e supply
and demand. Price can’t be controlled by an individual.
b. Value: It is the numerical measurement of utility obtained by person acquiring the
product. It is subjective in nature. It differs from person to person and situation to
situation. In finance, usually Value means Present value of future cash flows.
c. Decision making:
i. When Price < Value, it is said to be underpriced and it is good to buy.
ii. When Price > Value, it is said to be over-priced and it is good to sell
iii. When Price = Value, it is said to indifferent situation
3. Basics assumptions
a. Zero position: While making investment decisions, analysis is made irrespective whether
the source is own funds or borrowed funds.
b. Borrowed funds will have cost in terms of interest payment and owned funds will have
cost in in terms of opportunity cost or required rate of return
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1.2 Strategies and Framework

1. Framework
a. Strategic Management intends to run an organization in a systematized fashion by
developing a series of plans and policies known as strategic plans, functional policies,
structural plans and operational plans
b. Strategy + Finance + Management = Fundamentals of Business
i. Strategy : Objective
ii. Finance : Resources
iii. Management : Allocation
2. Strategy at Different Hierarchy Levels

a. Corporate level : Suitability, Feasibility, Acceptability
b. Business unit level : practical coordination of operating units
c. Functional level : functional business processes and value chain.
3. Basic Issues Addressed Under Financial Planning

a. Financial Resources + Financial Tools = Financial Goals
b. Profit Maximization versus Wealth Maximization
c. Credit Position
4. Interface of Financial Policy and Strategic Management

a. Mobilization of funds,
b. Capital structure
c. Fund allocation decisions
d. Dividend policy
5. Balancing Financial Goals Vis-a-Vis Sustainable Growth

a. Conflict can arise if growth objectives are not consistent with the value of the
organization's sustainable growth
b. sustainable growth rate (SGR), concept by Robert C. Higgins, of a firm is the maximum
rate of growth in sales that can be achieved, given the firm's profitability, asset utilization,
and desired dividend payout and debt (financial leverage) ratios.
c. SGR = ROE x (1- Dividend payment ratio)
d. Sustainable growth models assumptions
i. Business wants to maintain a target capital structure without issuing new equity;
ii. Maintain a target dividend payment ratio; and
iii. Increase sales as rapidly as market conditions allow.
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1.3 Formula basics

1. Compound interest
a. Meaning: It is the process of growing. It is interest earned on money that was previously
earned as interest. Hence the base of calculation of interest change every year. Therefore
formulae are based on multiplicative model rather than additive model
b. Terminologies
i. P: Value today is termed as Principle or Present value.
ii. r : Rate of interest. Interest for every Rs 100.Also referred as “I"
iii. t : Time period. Also referred as “n”
iv. F: Future value at the end of time period
c. Formulae
i. 𝐹 = 𝑃(1 + 𝑖)𝑛
𝐹
ii. 𝑃 = (1+𝑖)𝑛
iii. 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟
1
1. 𝐷𝐹 = (1+𝑖)𝑛
2. 𝐶𝑜𝑛𝑣𝑒𝑟𝑡𝑠 𝑜𝑛𝑒 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛𝑡𝑜 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
iv. 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟
1. Annuity factor =Sum of DF
1 1 1 1
2. 𝑃𝑉 = (1+𝑖)1
+ (1+𝑖)2 + (1+𝑖)3 + ⋯ … … (1+𝑖)𝑛
3. 𝐶𝑜𝑛𝑣𝑒𝑟𝑡𝑠 𝑚𝑎𝑛𝑦 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛𝑡𝑜 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
𝐿𝑜𝑎𝑛
v. 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡 = 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟
2. Compounding more than once a year
a. Meaning: Usually interest is compounded once a year i.e interest not paid in 1st year
becomes principal for 2nd year and so on. When compounding is done more than once
year, interest not paid in 1st period becomes principal for 2nd period and so on. Period
may be half yearly, monthly etc
b. Whenever the term compounded half yearly, monthly etc is used it is said to be nominal
rate
c. Effective rate of interest is the rate of interest which is converted from compounding
more than once a year into compounding p.a
d. List of adjusted formulae
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Compounding frequency Formula
𝑛
Annually 𝐹 =𝑃 1+𝑟
𝑟 2𝑛
Half yearly 𝐹 =𝑃 1+
2
𝑟 4𝑛
Quarterly 𝐹 =𝑃 1+
4
𝑟 12𝑛
Monthly 𝐹 =𝑃 1+
12
𝑟 ∞𝑛
𝐹 =𝑃 1+
∞
𝐹 = 𝑃𝑒 𝑟𝑛
Continuously
e will reflect 1+r
e= 2.7183
3. Average
a. Meaning: an average is a single number taken as representative of a list of numbers.
Different concepts of average are used in different contexts
b. Types
∑𝑥
i. Simple average, 𝑥̅ = 𝑛
∑ 𝑥𝑤
ii. weighted average, 𝑥̅ = ∑𝑤
iii. Average using probability, 𝑥̅ = ∑ 𝑥𝑝
X P(x) x*P(x)
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1.4 Summary chart
Decision
Making
Based on Basic
Criteria
Historical data Assumptions
Average Cost Benefit Zero position
Own money
Probability Price Value
also has cost
Opportunity
What you pay Receive
cost
Market factors Subjective
Supply PV of future
demand cash flows
Basics
Compounding interest Present value
F=P(1+r)n One time CF Consistent CF Installment
Multiplicative
Discounting factor Annuity Factor = loan/AF
model
(1+r) is FV for
every 1 Re 1/(1+r)n Sum of DF
investment
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Finding present value
• Year• Cash flow• Discounting factor• Discounted cash flow
• • • •
• • • •
• • • •
• • • • Total Present value
Compounding more than once a year
Compounding Formula
𝑛
Annually 𝐹 =𝑃 1+𝑟
𝑟 2𝑛
Half yearly 𝐹 =𝑃 1+
2
𝑟 4𝑛
Quarterly 𝐹 =𝑃 1+
4
𝑟 12𝑛
Monthly 𝐹 =𝑃 1+
12
𝑟 ∞𝑛
𝐹 =𝑃 1+
∞
Continuously
𝐹 = 𝑃𝑒 𝑟𝑛
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Computing e0.12
2.7183
√√√√√ √√√√√ √√√√√ (15 times)
-1
X0.12
+1
X= X= X= X= X= X= X= X= X= X= X= X= X= X= X= (15 times)
ex = 1 + x + x2 + x3 + x4
2 6 24
e0.12
= 1 + 0.12 + 0.122 + 0.123 + 0.124
2 6 24
= 1.12749
Expected value under probability
• X • P(x) • x*P(x)
• • •
• • •
• • •
• • • Total is E(x)
E(x) = Σpx where p is probability and x is random variable
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SECURITY VALUATION(BOND)
Marks distribution
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2.1 Basics
1. Bond :A fixed income security
2. Forms : Debenture,Bonds,Government securities,Treasury bills
3. Types
4. Par Value : Face value
5. Coupon Rate :
a. A bond carries a specific interest rate known as the coupon rate.
b. Coupon Amount = Par value of the bond × coupon rate.
c. It may be fixed rate or fluctuating rate
6. Types based on repayment
Type of repayment Interest payment, principal repayment

Regular bonds Coupon yearly + repayment at maturity
Annuity Yearly installments principle and interest
Perpetuity only coupon unless company is wound up
Zero coupon bonds only repayment
7. Frequency of Payment: The frequency of payment may be payable annually, semi annually,
quarterly or monthly)
8. Maturity Period : Period after which the bonds to be redeemed
2.2 Valuation of bonds

1. Basic formula
a. Value = Present of future cash flows i.e PV of coupons and redemption price
b. Remaining Cash flows to be considered i.e cash flows in remaining time to maturity.
c. Bond to be purchased when value of bond is more than bond price
2. Value of different types of bonds based on repayment

𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
a. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑅𝑒𝑔𝑢𝑙𝑎𝑟 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)1
+ (1+𝑘)2 + (1+𝑘)3 +. … . (1+𝑘)𝑛
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦
b. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)1 + (1+𝑘)2 + (1+𝑘)3 + ⋯ … … . (1+𝑘)𝑛
𝐶𝑜𝑢𝑝𝑜𝑛
c. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑏𝑜𝑛𝑑𝑠 = 𝑘
𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
d. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑍𝑒𝑟𝑜 𝑐𝑜𝑢𝑝𝑜𝑛 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)𝑛
Coupon = Face value * Coupon rate

K : required rate of return
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2.3 Yield to maturity YTM

1. Meaning
a. YTM is the rate at which the present value of cash flows from the bond is equated to
current market price of bond
b. Higher the YTM higher the return generated by the bond
c. Bond should be purchased(Underpriced) if YTM > Cost of capital
d. YTM is similar to Internal rate of return
2. Formula
𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
a. 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑅𝑒𝑔𝑢𝑙𝑎𝑟 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)1
+ (1+𝑘)2 + (1+𝑘)3 +. … . (1+𝑘)𝑛
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦
e. 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)1 + (1+𝑘)2 + (1+𝑘)3 + ⋯ … … . (1+𝑘)𝑛
𝐶𝑜𝑢𝑝𝑜𝑛
f. 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑏𝑜𝑛𝑑𝑠 = 𝑘
𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
g. 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑍𝑒𝑟𝑜 𝑐𝑜𝑢𝑝𝑜𝑛 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)𝑛
Coupon = Face value * Coupon rate

K : YTM
Apply Interpolation method to get YTM
3. Approximate formula
𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒−𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
𝐶𝑜𝑢𝑝𝑜𝑛+
𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑙𝑖𝑓𝑒
𝑌𝑇𝑀 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒+𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
2
4. Other points to noted
a. Formula for value of bond and price of bond looks similar, but the difference is in
discounting rate. In market price, YTM is used where as in Value of bond, required rate
of return is used
b. When there is no information , we assume price = value of bond and YTM = required rate
of return
c. If no information is available on redemption price, it is assumed to be same as face value
5. Realised YTM
a. Meaning: It is the modified YTM by considering the actual rate of reinvestment of cash
flows that occur during the period of holding
b. How YTM is different from Realised YTM: Normal YTM assumes that coupon received
is reinvested at YTM rate. Actual reinvestment may be different. Such reinvestment rate
is called as Realised YTM
c. Steps in computing Realized YTM
i. Step 1 Compute Maturity value of each cash flow
ii. Step 2 Apply Compound interest formula
F = Maturity Value , P = Current market price, n = residual maturity
iii. Step 3 Compute interest rate = Realised YTM
Use interpolation method or trial and error
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2.4 Duration (Macaulay duration)

1. Meaning: It calculates the weighted average time before a bondholder would receive the bond's
cash flows. It can also be referred as average recovery period. If each coupon is considered as
independent bond, the marker price paid will include the right to receive multiple cash inflows
with different maturity periods. Average of such maturity periods is called as duration of bond. It
will always be less than maturity of the bond. For a ZCB, Residual time to maturity = Duration of
bond because of one time inflow. And no specific duration for perpetual bond
2. Application
a. It is referred as optimum holding period because,this is the period upto which interest rate
risk is lowest and after which it increases
b. It is often used by bond managers looking to manage bond portfolio risk with
immunization strategies
3. Formula:
a. Basic formula of Duration = Sum of products of time period with amount
Sum of amount
= Time * PV of cash flows at YTM
Market price
𝟏+𝒀𝑻𝑴 (𝟏+𝒀𝑻𝑴)+𝒕(𝒄−𝒀𝑻𝑴)
b. Shortcut formula of duration = 𝒀𝑻𝑴
− 𝒄[(𝟏+𝒀𝑻𝑴)𝒕−𝟏]+𝒀𝑻𝑴
Where Where YTM = Yield to Maturity, c= Coupon Rate, Years to Maturity
4. Bond Immunization
a. It is a portfolio of fixed income securities. It is applicable when an investor needs money
after a certain period, and no bond is available for such corresponding period. In such
case he will invest in multiple bonds, One bond having higher maturity and the other
lower maturity.
b. Investment should be done in such a way that weighted average of duration of two bonds
should be equal to expected holding period.
c. It involves following steps
i. Step 1 : Determine duration of the bonds under consideration
ii. Step 2 : Compute the proportion of investment as below
D1 *W1 + D2*(1-W1) = Holding period
where D1 is duration in bond1,W1 is weight in bond1
D2 is duration in bond2, 1-W1 is weight in bond1
iii. Step 3 : Compute PV of Amount required
iv. Step 4 : Divide PV (As in step 3) in proportion as determined in step2 which will
provide amount to be invested in each bond
7
2.5 Volatility of bond or modified duration

1. Meaning: It is approximate measure of a bond's price sensitivity to changes in interest rates. The
modified duration determines the changes in a bond's duration and price for each percentage
change in the yield to maturity. It is the proportionate relation between YTM and market Price.
Example, If volatility = 2 means , if YTM increases by 1%, market price decreases by 2%
2. Formula, Volatility= Duration/(1+YTM)
3. Application :
a. If you expect rates to rise, it may make sense to focus on shorter-duration investments (in
other words, those that have less interest-rate risk). Or, in this sort of environment, you
may want to focus on bonds that take on different types of risks, which is less affected by
movements in interest rates
b. If you expect rates to fall, then long duration bonds are advantageous
2.6 Convexity
1. Meaning :
a. It is the rate of change in modified duration with respect to change in market price. It is
the second derivative w.r.t YTM and Market price
b. It is an accurate measure of price sensitivity to changes in interest rates. Convexity is a
measure of the curvature in the relationship between bond prices and bond yields.
Convexity demonstrates how the duration of a bond changes as the interest rate changes.
2. Application:
a. If a bond's duration increases as yields increase, the bond is said to have negative
convexity.
b. If a bond's duration rises and yields fall, the bond is said to have positive convexity.
c. As convexity increases, the systemic risk to which the portfolio is exposed increases.
𝑃𝑟𝑖𝑐𝑒 𝑖𝑓 𝑌𝑇𝑀 ↑ +𝑃𝑟𝑖𝑐𝑒 𝑖𝑓 𝑌𝑇𝑀 ↓−2(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒)
3. Formula : 𝐶 =
2(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒)(∆ 𝑌𝑇𝑀)2
4. Convexity Vs Volatility
a. Though measures sensitivity, convexity is more accurate than volatility
b. Volatility measures linear relationship between price and YTM, where as convexity
measures curve nature of relationship.
c. As the changes in interest rate increase, deviation between convexity and volatility also
change.
d. Difference between volatility and convexity is called as convexity adjustment calculated
as follows, Adjustment = C ∗ (∆ 𝒀𝑻𝑴)𝟐
7
2.7 Problems on Duration and volatility

Problem No 1. Simple problem on duration and volatility
The bond has five years to maturity and the coupon rate on the bond is 15% p.a. payable annually.
Current Market Price 1025.86(Face value Rs. 1000). YTM is 14.24%. Compute Duration and
volatility.
(Answer Hint :3.87 years, 3.388 times )
Problem No 1. Duration and volatility
The following data are available for a bond

• Face value Rs 1,000,
• Coupon Rate 12%
• Years to Maturity 5,
• Redemption value Rs 1,000
• Yield to maturity 9%
What is the current market price, duration and volatility of this bond?
Compute the market price if YTM increases by 20bp
(Answer Hint : 4.09 years, 3.75 times ,Rs = 1108.28 )
Problem No 2. Impact of change in YTM

RTP November 2011,RTP November 2012,RTP May 2016

• Coupon Rate 16%
What is the current market price, duration and volatility of this bond? Also, Calculate the expected
market price, if increase in required yield is by 75 basis points
(Answer Hint : 964.24, 4.24 years, 3.6258 times, Rs 938.14)
Problem No 3. Change in YTM (June 2009) (8Marks)
Consider two bonds, one with 5 years to maturity and the other with 20 years to maturity. Both the
bonds have a face value of Rs. 1,000 and coupon rate of 8% (with annual interest payments) and both
are selling at par.
Assume that the yields of both the bonds fall to 6%, whether the price of bond will increase or
decrease?
What percentage of this increase/decrease comes from a change in the present value of bond’s
principal amount and what percentage of this increase/decrease comes from a change in the present
value of bond’s interest payments?
(Answer Hint : IF YIELD FALLS TO 6% Price of 5yr. bond is Rs. 1,083.96 , Current price of 20 year
bond is Rs. 1229.60
7
PRICE INCREASE DUE TO CHANGE IN PV OF PRINCIPAL 5 yrs. Bond is 78.6%, 20 yrs. Bond
is 42.68%
PRICE INCREASE DUE TO CHANGE IN PV OF INTEREST 5 yrs. Bond is 20.86%, 20 yrs. Bond
is 57.49%)
Problem No 4. Change in YTM and duration (6+3 Marks) (June 2009)
Consider a bond selling at its par value of Rs 1,000, with 6 years to maturity and a 7% coupon rate
(with annual interest payment), what is bond’s duration. If the YTM of the bond above increases to
10%, how it affects the bond’s duration? And why?
(Answer Hint : 5.098 years, New Duration Rs. 4,366.45/ Rs. 868.85 = 5.025 years The duration of
bond decreases, reason being the receipt of slightly higher portion of one’s investment on the same
intervals.)
Problem No 5. Change in YTM and market price

November 2015(5 Marks),RTP May 2018, ,MTP May 2019
The following data is available for a bond:
Face Value Rs 1,000

Coupon Rate 11%
Years to Maturity 6
Redemption Value Rs 1,000
Yield to Maturity 15%
(Round-off your answers to 3 decimals)
Calculate the following in respect of the bond:

(i) Current Market Price.
(ii) Duration of the Bond.
(iii) Volatility of the Bond.
(iv) Expected market price if increase in required yield is by 100 basis points.
(v) Expected market price if decrease in required yield is by 75 basis points.
(Answer Hint : (i) Market price: Rs 834.48 , (ii) Duration = 4.57 years (iii) Volatility = 3.974 (iv) =
Rs 815 (v) = Rs 875)
Problem No 6. Duration for decision making RTP May 2014
Mr. A is planning for making investment in bonds of one of the two companies X Ltd. and Y Ltd. The
detail of these bonds is as follows:
Company Face Value Coupon Rate Maturity Period

X Ltd. Rs 10,000 6% 5 Years
Y Ltd. Rs 10,000 4% 5 Years
The current market price of X Ltd.’s bond is Rs 10,796.80 and both bonds have same Yield To
Maturity (YTM). Since Mr. A considers duration of bonds as the basis of decision making, you are
required to calculate the duration of each bond and you decision
(Answer Hint : Duration of X Ltd.’ s Bond 4.49 years, Duration of Y Ltd.’s Bond 4.63 years )
7
Problem No 7. Half yearly coupon and duration RTP May 2012,November 2008(6 Marks)
XL Ispat Ltd. has made an issue of 14 per cent non-convertible debentures on January 1,2011. These
debentures have a face value of Rs 100 and is currently traded in the market at a price of Rs 90.
Interest on these NCDs will be paid through post-dated cheques dated June 30 and December31.
Interest payments for the first 3 years will be paid in advance through post-dated cheques while for
the last 2 years post-dated cheques will be issued at the third year. The bond is redeemable at par on
December 31, 2015 at the end of 5 years.
Required :
(i) Estimate the current yield at the YTM of the bond.
(i) Calculate the duration of the NCD.
(ii) Assuming that intermediate coupon payments are, not available for reinvestment calculate the
realised yield on the NCD.
(Answer Hint : 15.55%/17.14%, 3.85 years, 13.56%)

Author note: Same as next question.But solution different. But next solution is preferred since it has
appropriately taken the impact of half yearly compounding
Problem No 8. Half yearly coupon and duration RTP May 2018
XL Ispat Ltd. has made an issue of 14 per cent non-convertible debentures on January 1,2007. These
debentures have a face value of Rs 100 and is currently traded in the market at a price of Rs 90.
Interest on these NCDs will be paid through post-dated cheques dated June 30 and December31.
Interest payments for the first 3 years will be paid in advance through post-dated cheques while for
the last 2 years post-dated cheques will be issued at the third year. The bond is redeemable at par on
December 31, 2011 at the end of 5 years.
Required :
(i) Estimate the current yield at the YTM of the bond.
(ii) Calculate the duration of the NCD.
(iii) Assuming that intermediate coupon payments are, not available for reinvestment calculate the
realised yield on the NCD.
(Answer Hint : (i) Current yield =15.55% , YTM = 8.54% semi annually (ii) Duration = 3.683 years,
(iii) 12.76%)
Problem No 9. Duration reverse calculation Practice Manual(Old)
Find the current market price of a bond having face value Rs 1,00,000 redeemable after 6 year
maturity with YTM at 16% payable annually and duration 4.3202 years. Given 1.166 = 2.4364
(Answer Hint : Rs96,275/-.)
Problem No 10. Bond Immunization

November 2015(6 Marks), MTP November 2018, MTP November 2019,RTP November 2021
Mr. A will need Rs 1,00,000 after two years for which he wants to make one time necessary
investment now. He has a choice of two types of bonds. Their details are as below:
Bond X Bond Y
7
Face value Rs 1,000 Rs 1,000

Coupon 7% payable annually 8% payable annually
Years to maturity 1 4
Current price Rs 972.73 Rs 936.52
Current yield 10% 10%
Advice Mr. A whether he should invest all his money in one type of bond or he should buy both the
bonds and, if so, in which quantity? Assume that there will not be any call risk or default risk.
(Answer Hint : 52 bonds, 34 bonds)
Problem No 11. Bond Immunization November 2018(N)(12 Marks), MTP May 2020, MTP
June 2021
The following data are available for three bonds A, B and C. These bonds are used by a bond portfolio
manager to fund an outflow scheduled in 6 years. Current yield is 9%. All bonds have face value of
Rs100 each and will be redeemed at par. Interest is payable annually
Bond Maturity (Years) Coupon rate

A 10 10%
B 8 11%
C 5 9%
(i) Calculate the duration of each bond.

(ii) The bond portfolio manager has been asked to keep 45% of the portfolio money in Bond A.
Calculate the percentage amount to be invested in bonds B and C that need to be purchased to
immunise the portfolio.
(iii) After the portfolio has been formulated, an interest rate change occurs, increasing the yield to
11%. The new duration of these bonds are: Bond A = 7.15 Years, Bond B = 6.03 Years and Bond
C = 4.27 years. Is the portfolio still immunized? Why or why not?
(iv) Determine the new percentage of B and C bonds that are needed to immunize the portfolio. Bond
A remaining at 45% of the portfolio.
(Answer Hint : (i) Duration of the bond is 6.86, 5.84, 4.24 (ii) the % of investment of B and C is
35.34% or 36.21% and 19.66 % or 18.79% respectively (iii) revised yield the Revised = 6.20 year (iv)
the % of investment of B and C is 24.66% or 25% and 30.34 % or 30.00% respectively.)
7
2.8 Yield Curve:
1. Meaning: It shows how yield to maturity is related to term to maturity for bonds that are similar in
all respects, except maturity. Normally, as the maturity increases, yield also increase. Yield is like
an average rate for certain number of years.
2. Example
Time YTM
3M 6.0%
6M 8.0%
1Y 8.5%
2Y 10.0%
3Y 11.0%
5Y 14.0%
10Y 15.0%
3. Forward rate:
a. It is the implicit rate applicable for a specific period calculated based on yield between
two periods.
b. A forward rate is an interest rate applicable to a financial transaction that will take place
in the future
4. Relationship between forward rate and yield
a. (1+ FR1) = (1+YTM1)
b. (1+ FR1) (1+ FR2) = (1+YTM2)2
c. (1+ FR1) (1+ FR2) (1+ FR3) = (1+YTM3)3
d. (1+ FR1) (1+ FR2) (1+ FR3) (1+ FR4) = (1+YTM4)4
5. Present value calculation using Forward rates and YTM
1 𝐶𝐹 𝐶𝐹 2 𝐶𝐹
3
a. 𝑃𝑉 = (1+𝑌𝑇𝑀 )1
+ (1+𝑌𝑇𝑀 )2
+ (1+𝑌𝑇𝑀 3
+ ⋯…
1 2 3)
𝐶𝐹 𝐶𝐹2 𝐶𝐹3
b. 𝑃𝑉 = (1+𝐹𝑅1 1
+ (1+𝐹𝑅 1 2
+ (1+𝐹𝑅 1 2 3
+⋯…
1) 1 ) (1+𝐹𝑅2 ) 1 ) (1+𝐹𝑅2 ) (1+𝐹𝑅3 )
7
2.9 Bond Replacement decision

1. Meaning:
a. Callable bond where issuer has right to redeem the bond at any time.
b. Puttable bond where the holder has right to be redeemed at any time.
2. Need for replacement

a. When there is a decrease in interest rates in market due to various macro factors such as
supply of money, political changes etc the issuer of fixed rate bonds cannot enjoy the
benefit of falling interest rates since the outflow of coupon is already fixed.
b. To get such benefit of falling interest rates , issuer can redeem existing bonds pre-
maturely and can issue the new bonds at present rate of interest. This will involve various
costs such as call premium, floatation cost etc. Therefore, bond replacement decision will
be based net benefit after considering cost and savings in interest. This has following
steps.
3. Cash flows involved in replacement decision.

a. Replacement if NPV > 0
b. Initial cash flow
i. Payment of old bonds(Face value + Premium)
ii. Proceeds of new bonds ( Face value – Issue expenses)
iii. Tax savings on Unamortized amount on old bond
iv. Tax savings on Premium amount on old bond
v. Overlapping interest
c. Interim cash flows
i. Savings in annual interest (1 – t)
ii. Tax benefit on Amortization differential
d. Terminal cash flow
i. Differential between redemption value of new bond and old bond
ii. When both bonds are redeemed at par, differential will be zero
4. Format for working note
Particulars Don’t replace Replace the bond Incremental

the bond Cash flows
Initial Cash No cash flow Repayment of existing bonds (-) Differential
flow Call premium*(1-t) (-) (A)
Issue new bonds (+)
Issue cost on new bonds (-)
Tax impact on unamortized issue
cost of old bonds (Unamortized
issue cost*t) (+)
Interest in overlapping period
(-)
Interim Existing New coupon(1-t) Differential
cash flow coupon(1-t) (B)
7
Existing New Amortization cost *t Differential

Amortization (C)
cost*t
Net D=C-B
Savings
Terminal Redeemable Redeemable value of New bonds Differential
cash flows value of old (E)
bonds
5. NPV calculation
a. = Interim cash flows(D) * Annuity factor + Terminal cash flows(E)* Discounting factor –
Initial cash flows(A)
b. Replace the bond if NPV > 0
7
2.10 Convertible bonds

1. Meaning
a. A bond where the holder at his option convert bonds to shares at a conversion ratio.
b. It usually carries lower coupon than normal bonds/Straight bond
2. Terms associated
a. Conversion ratio : It is the number of shares that investor would receive for every bond.
This may be fixed or variable.
b. Straight value of bond : It is the value of non-convertible bond. It is computed by PV of
coupon and redemption price of convertible bond discounted using coupon of bond
without conversion option
c. Conversion value of bond or stock value of bond : It is the value of investment if bond is
converted into shares. It is calculated by conversion ratio * Market price per share
d. Conversion premium per bond
i. Meaning : It means excess paid to remain as bond holder over becoming
shareholder
ii. Computation:
(a) Conversion premium per bond= Market price of convertible bond –
Conversion value of bond
(b) Conversion premium per share = Conversion premium per
bond/conversion ratio
(c) Conversion premium % = Conversion premium per bond/ Conversion
value of bond
e. Downsize risk : It is the loss that the convertible bond holder would face if there is no
value for conversion. It is calculated by
MP of convertible bond – Straight value of bond*100
MP of convertible bond or straight value of bond
f. Conversion parity price : It is the indifference point between investment in bonds and
getting converted into shares. If Market price of share is above parity price, then it is
beneficial to convert . If Market price of share is below parity price, then it is beneficial to
remain invested in bonds.
i. Parity price = MP of convertible bonds/Conversion ratio
ii. At parity price = Premium will be zero
iii. Current Market price per share = Parity Price + Premium per share
g. Favourable income differential per share
Coupon Interest - Conversion Ratio* Dividend Per Share
Conversion Ratio
h. (g) Premium pay back period
Conversion premium per share
Favourable Income Differntial Per Share
7
2.11 Summary chart
Bond
Type of
Meaning Forms Types
repayment
Instrument Corporate Fixed rate Floating

representing Regular
bonds bonds rate bonds
debt
Interest
Governmen
rate is Annuity
t Securities Interest variable
income
Treasury
Perpetuity
bills
and
redemptio
n price is Zero
Commerci
fixed coupon
al Papers
bonds
Cash flows in
Value of Bond = Price of bond=
Bond
Initial Cash Interim Terminal Discountin PV of Cash Discountin

PV of CF
flow cash flow cash flow g rate flows g rate
Market Redemptio PV of required PV of

Coupons YTM
Price n Price Coupon rate of Coupon
return
+ +
PV of redemption PV of redemption
price price
Value of bonds
Value = coupon + Coupon +Coupon +………Redemption Price
(1 + k)1 (1 + k)2 (1 + k)3 (1 + k)n
Value of bond = ( Coupon * AF) + (Redemption price * DF)
Computation format
Year Cash flow Annuity factor Discounted cash flow
1to3 Coupon
3 Redemption price
Total Value of bond
7
Yield to maturity YTM

Formula
Price = Interest + Interest + Interest +……Redemption Price
(1 + YTM)1 (1 + YTM)2 (1 + YTM)3 (1 + YTM)n
Apply Interpolation method to get YTM

Approximate formula
Redemption price −current price

Coupon+( )
n
YTM= Redemption price+current price
2
Duration of bond
Duration = Time * PV at YTM
Market price
Year CF DF@YTM DCF Product

Coupon
Coupon
Coupon
Coupon + Redemption Price
∑ 𝑥𝑤
Duration = Sum of products of time period with amount ( ∑𝑤 )
Sum of amount
Volatility = Duration/(1+YTM)
Forward rates
(1+ FR1) = (1+YTM1)
(1+ FR1) (1+ FR2) = (1+YTM2)2
(1+ FR1) (1+ FR2) (1+ FR3) = (1+YTM3)3
(1+ FR1) (1+ FR2) (1+ FR3) (1+ FR4) = (1+YTM4)4
PV = CF1 + CF2 + CF3________

(1+FR1) (1+FR1)(1+FR2) (1+FR1)(1+FR2)(1+FR3)
Note: Forward rate is applicable for a particular year, YTM is the average rate for certain number of
years.
Bond Replacement decision

Continue With Redeem old and Incremental cash
existing Bond issue new bond flow
Initial cash flow
Redemption of old bond
Call premium after tax
Issue of new bonds
Issue cost of new bonds
7
Tax impact of Unamortised

issue cost of old bonds
Interim cash flow

Interest cost
Amortization of issue cost
Terminal cash flow

Redemption
If NPV > 0, Replace
Convertible bonds basics

A bond where the holder at his option convert bonds to shares at a conversion ratio.
It usually carries lower coupon than normal bonds/Straight bond
Stock value of bond/conversion value
= (Market price of share * Conversion ratio )
Conversion premium
= Market price of convertible bond - (Market price of share * Conversion ratio )
Downsize risk
= (Convertible bond – Straight bond)/Convertible bond
Conversion parity price/market conversion price
= Convertible bond price / conversion ratio
Bond Immunization steps

Step 1 : Determine duration of the bonds under consideration
Step 2 : Compute the proportion of investment as below
D1 *W1 + D2*(1-W1) = Holding period
where D1 is duration in bond1 and W1 is weight in bond1
D2 is duration in bond2 and 1-W1 is weight in bond1
Step 3 : Compute PV of Amount required
Step 4 : Divide PV in proportion as determined in step2 which will provide amount to be invested in
each bond
7
2.12 Problems
Problem No 1. Basics on valuation
Par value of bond Rs.100, Years to maturity 5 years, Coupon rate of interest 10%, Find value of bond
if Required rate of return is (a) 12% (b) 8% (c) 10%
(Answer Hint : Rs92.79,Rs107.99,100 )
Problem No 2. Required rate of return impact
Par value of bond Rs.100, Years to maturity 8 years, Coupon rate of interest 10%, Find value of bond
if Required rate of return is
(a) 12%
(b) 8%
(c) 10%
(Answer Hint : 90.07,111.5,100 )
Problem No 3. Basics on valuation

RTP November 2013,MTP November 2013, MTP May 2014
Nominal value of 10% bonds issued by a company is Rs100. The bonds are redeemable at Rs110 at
the end of year 5.
Determine the value of the bond if required yield is
(i) 5%,
(ii) 5.1%,
(iii) 10%
(iv) 10.1%
(Answer Hint : Rs 129.48,128.953,106.207,105.802)
Problem No 4. Semi-annual coupon Practice Manual(Old)
If a Rs.100 par value bond carries a coupon rate of 12 per cent and a maturity period of 8 years and
interest payable semi-annually then the value of the bond with required rate of return of 14 per cent
will be what?
(Answer Hint : 90.55)
Problem No 5. Multiple coupons November 2003 (8 Marks),RTP May 2020
M/s Agfa Industries is planning to issue a debenture series on the following terms:
• Face value Rs 100
• Term of maturity 10 years
• Yearly coupon rate are as follows
Years Coupon
7
1 − 4 9%
5 − 8 10%
9 − 10 14%
Required rate of return 16 %p.a. The Company also proposes to redeem the debentures at 5 per cent
premium on maturity. Determine the issue price of the debentures.
(Answer Hint : Rs 71.327)
Problem No 6. Multiple coupons May 2016(5 Marks)
Bright Computers Limited is planning to issue a debenture series with a face value of Rs 1,000 each
for a term of 10 years with the following coupon rates:
Years Rates
1-4 8%
5-8 9%
9-10 13%
The current market rate on similar debenture is 15% p.a. The company proposes to price the issue in
such a way that a yield of 16% compounded rate of return is received by the investors. The
redeemable price of the debenture will be at 10% premium on maturity.
What should be the issue price of debenture?

Pv @ 16% for 1 to 10 years are: .862, .743, .641, .552, .476, .410, .354, .305, .263, .227 Respectively
Problem No 7. ZCB valuation
A company issues ZCB with maturity period of 5 years to be redeemed at Rs.7247. If required rate of
return is 10%, compute the value of bond
(Answer Hint : Rs. 4500 )
Problem No 8. Annuity bonds
Mr.X is interested in investing in a bond which has following features

• Period 3 years,
• Annuity Rs 40211,
Compute value annuity bond at required rate of 12% p.a
(Answer Hint : 96579)
Problem No 9. Perpetual bond
A company issued perpetual bond on 1.1.2019 having coupon rate of 10% with par value of Rs.1000.
As 1.1.2020 an investor is interested in purchasing this bond. Compute the value of bond if required
rate of return is 12.5%
(Answer Hint : 800)
Problem No 10. Purchase on different dates
Mr.Sundar is planning to invest in a Bond of a company having face value of Rs.1000
7
Relevant data
• Date of issue of Bond : 1.4.2007,
• Date of redemption of bond : 31.3.2022
• Coupon rate : 12% p.a,
• Coupon date payment : 31st March every year
• Sundar require rate of return of 10% p.a
Compute the value of bond if he decides to purchase on following dates

• Alternative 1 : on 1.4.2017,
• Alternative 2 : on 1.10.2017
(Answer Hint : 1075.80, 1128.32 )
Problem No 11. Floating rate bond
Mr.Ramesh is planning to invest in a Bond of a company having face value of Rs.1000

Relevant data
• Date of issue of Bond : 1.4.2007
• Date of redemption of bond : 31.3.2022
• Coupon rate : Floating rate
• Coupon date payment : 31st March every year
Compute the value of bond if he decides to purchase on following dates

• Alternative 1 : on 1.4.2017(Prevailing market rate 12%)
Alternative 2 : on 1.10.2017
Problem No 12. Basics of YTM November 2011(4 Marks),RTP May 2019
Based on the credit rating of bonds, Mr. Z has decided to apply the following discount rates for
valuing bonds:
Credit Rating Discount Rate

AAA 364 day T bill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread
He is considering to invest in AA rated, Rs1,000 face value bond currently selling at Rs1,025.86.
The next interest payment is due one year from today and the bond is redeemable at par. (Assume the
364 day T-bill rate to be 9%).
You are required to find Yield to Maturity (YTM) of the bond
(Answer Hint : 14.24%)
Problem No 13. YTM Calculation
Find YTM from information below compute YTM
7
• Market price 750

• Par value 1000
• Coupon rate 12%
• Years to maturity 7 years
Problem No 14. Simple problem on duration and volatility
Current Market Price 1025.86(Face value Rs. 1000). YTM is 14.24%. Compute Duration and
volatility.
(Answer Hint :3.87 years, 3.388 times )
Problem No 15. Duration and volatility

• Coupon Rate 12%
What is the current market price, duration and volatility of this bond?
Compute the market price if YTM increases by 20bp
(Answer Hint : 4.09 years, 3.75 times ,Rs = 1108.28 )
Problem No 16. Bond Immunization

November 2015(6 Marks), MTP November 2018, MTP November 2019,RTP November 2021
Mr. A will need Rs 1,00,000 after two years for which he wants to make one time necessary
investment now. He has a choice of two types of bonds. Their details are as below:
Advice Mr. A whether he should invest all his money in one type of bond or he should buy both the
Bond X Bond Y
Face value Rs 1,000 Rs 1,000
Coupon 7% payable annually 8% payable annually
Years to maturity 1 4
Current price Rs 972.73 Rs 936.52
Current yield 10% 10%
bonds and, if so, in which quantity? Assume that there will not be any call risk or default risk.
(Answer Hint : 52 bonds, 34 bonds)
Problem No 17. Implicit forward rate November 2008(4 Marks),RTP November 2016
The following is the Yield structure of AAA rated debenture:
Period Yield (%)

3 months 8.5
7
6 months 9.25
1 year 10.50
2 years 11.25
3 years and above 12.00
(i) Based on the expectation theory calculate the implicit one-year forward rates in year 2 and year 3.
(ii) If the interest rate increases by 50 basis points, what will be the percentage change in the price of
the bond having a maturity of 5 years? Assume that the bond is fairly priced at the moment at Rs
1,000.
(Answer Hint : 12%,13.52%,2.2% )
Problem No 18. Bond Replacement RTP November 2014,RTP November 2016,MTP July
2021
M/s Transindia Ltd. is contemplating calling Rs 3 crores of 10 years, Rs 1,000 bond issued 5 years
ago with a coupon interest rate of 14 per cent. The bonds have a call price of Rs 1,015 and had
initially collected proceeds of Rs 2.91 crores due to a discount of Rs 30 per bond. The initial floating
cost was Rs 3,60,000. The Company intends to sell Rs 3 crores of 12 per cent coupon rate, 5 years
bonds to raise funds for retiring the old bonds. It proposes to sell the new bonds at their par value of
Rs 1,000. The estimated floatation cost is Rs 2,00,000. The company is paying 40% tax. The new
bonds shall be issued 2 months before retiring old bonds to avoid any market risk and using the
proceeds from new issue to retire the old bonds.
What is the feasibility of refunding bonds?

(Answer Hint : NPV 6.89 lakhs)
Problem No 19. Convertible bonds Practice Manual(Old)
A convertible bond with a face value of Rs 1,000 is issued at Rs 1,350 with a coupon rate of 10.5%.
The conversion rate is 14 shares per bond. The current market price of bond and share is Rs 1,475 and
Rs 80 respectively.
What is the premium over conversion value?
Problem No 20. Intrinsic value and beta of bond MTP May 2021
ABC Ltd. wants to issue 9% Bonds redeemable in 5 years at its face value of Rs. 1,000 each.
The annual spot yield curve for similar risk class of Bond is as follows:
Year Interest Rate

1 12%
2 11.62%
3 11.33%
4 11.06%
5 10.80%
(i) Evaluate the expected market price of the Bond if it has a Beta value of 1.10 due to its
popularity because of lesser risk.
(ii) Interpret the nature of the above yield curve and reasons for the same.
Note: Use PV Factors upto 4 decimal points and value in Rs. upto 2 decimal points.
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CORPORATE VALUATION (EQUITY)

Marks distribution
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3.1 Basics of valuation

1. Meaning:
a. It is the process of assigning a number to a asset based its worth by using the asset.
b. An analyst placing a value on a company looks at the business's management, the
composition of its capital structure, the prospect of future earnings, and the market value
of its assets, among other metrics
c. A quote by Aswath Damodaran: “ “Valuation is not an objective exercise, and any
preconceptions and biases that an analyst brings to the process will find their way into
value”.
d. A business valuation is an activity conducted towards rendering an estimate or opinion as
to the fair market value of a business interest at a given point in time
e. Business valuation is no precise science. There is no universal legal framework which
dictates how the valuation should be performed. Therefore, it is no right way to estimate
the value of a company, its equity shares or an identified cash generation unit
2. Purposes and Instances of valuation
a. Purposes
i. Valuation for transactions
ii. Valuation for compliance
b. Instances
i. Mergers and acquisitions.
ii. Investment in stock market
iii. Financial reporting
iv. Mutual funds investment
v. Business restructuring;
vi. Initial public offering and listing of equity shares in stock exchanges;
vii. Shareholders’ disputes settlement;
viii. Damage claims;
3. Distinction between Price and Value
a. Price is what amount paid determined by market forces, i.e demand and supplu
b. Value is what you receive by possessing and using the product. It is subjective in nature
4. Principles of Valuation
a. Incremental value of obtaining the asset
b. Time value of money
c. Risk and return
i. Internal rate of return
ii. Return in investment
iii. Concept of ratio or valuation multiple
5. Types of value
a. Book value
b. Present value
c. Market value(price)
6. Approaches or valuation models
a. Book value based
i. Equity valuation
1. Shareholders’ Funds = Share capital + Reserves & Surplus
2. Intrinsic value or book value per share =
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Market value of assets – Liabilities

No of shares
ii. Firm valuation
1. Enterprise value = Shareholders funds + Value of debt – Cash
2. Value of business = Equity + Debt
b. Income based
i. Earnings capitalization
1. Value of business = Income/ required rate of return
2. MPS = EPS/ Required rate of return
ii. Using valuation multiple
1. Using PE ratio
a. Marker price per share = EPS * PE ratio
b. Market capitalization = Net profit * PE ratio
2. Using Price to sales ratio
a. Value of business = Sales* Price to sales ratio
3. Using EV to EBITDA
a. Enterprise value = EBITDA * EV to EBITDA ratio
4. Summary table
Quantity X Multiple Terminology = Value
Cash Flow X Firm Value / Cash Flow of Firm Cash flow multiple” = Value of Firm
EBITDA X Firm Value / EBITDA of Firm EBITDA multiple” = Value of Firm
Sales X Firm Value / Sales Value of Firm Sales multiple” = Value of Firm
Customers X Firm Value / Customers Customer multiple” = Value of Firm
Earnings X Price per Share / Earnings Price-earnings ratio” = Share Price
c. Cash flow-based valuation (Discounted cash flow method)

i. For shareholders
1. Dividend based model
ii. For company
1. Free cash flow to Firm (FCFF)
2. Free cash flow to Equity(FCFE)
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3.2 Dividend based valuation

1. Basics
a. Meaning: That portion of profit (after tax) which is distributed among the
owners/shareholders of the firm is known as dividends. Profit which is not distributed is
known as retained earnings.
b. Dividend Policy and dividend decisions are influenced by
i. Long Term Financing Decision
1. When there is investment opportunity for growth
2. Dividend can be used as financing
ii. Wealth Maximization Decision:
1. Higher dividends increase value of shares
2. investment opportunities for lack of funds and thereby decrease the future
earnings
iii. Liquidity
1. Affects liquidity position as it involves outflow of cash
2. Ability to pay dividends depends on cash and liquidity position
iv. Legal Constraints
1. Section 205(1) of the Companies Act 1956,
2. Section 123 of companies act, 2013
v. Stability of dividends
1. Constant Dividend per Share:
2. Constant Pay out ratio
3. Small Constant Dividend per Share plus Extra Dividend
vi. Type of dividend
1. Cash dividend
c. Stock dividend
2. Basic terms
a. Dividend terms
i. Do means dividend just paid
ii. D1 means Dividend payable at the end of year 1
iii. D1 = Do (1 + growth in year 1)
iv. D2 = D1 ( 1 + growth in year2 )
b. P1 means price expected in year1, P0 means current market price
c. Return from share price = P1 - P0 +D1
P0
d. Payout ratio = DPS/EPS and Retention ratio = 1 – payout ratio
e. Cost of capital is reciprocal of P.E ratio (Ke=1/P.E ratio)
f. Cost of equity under CAPM
g. Ke = Rf + (Rm-Rf)* β where Rf: Risk free rate, Rm : Market rate and β:beta
factor
3. Theories on Dividend Policies
a. Optimal dividend policy is a policy which maximizes share price
b. The important theories are as follows
i. Walter Approach
ii. Gordon Growth Model
iii. Modigliani and Miller (MM) Hypothesis
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iv. Linter’s Model

v. Traditional
3.2.1 Walter Approach
1. Given by Prof. James E. Walter

2. Theory
a. Dividend policy linked to cost of capital of company(shareholders expectation) and
required rate of return from assets
b. If Ra<Rc, Optimum pay out is 100%, if Ra > Rc , optimum pay out is 0%
c. Money who should be with person whoever can get better return
d. if the internal return of retained earnings is higher than market capitalisation rate, the
value of ordinary shares would be high even if dividends are low
3. Formula
Market price = DPS + Ra (EPS- DPS)
Rc .
Rc
Where Ra is return on investment and Rc is overall cost of capital
3.2.2 Gordon Growth Model
1. Given by Myron Gordon

2. Theory
a. Shareholders prefer to pay a higher price for shares on which current dividends are
paid
b. They would discount the value of shares of a firm which postpones dividends
c. Assumptions
i. The firm is an all equity firm, and it has no debt
ii. The internal rate of return, r, of the firm is constant
iii. The appropriate discount rate, ke, for the firm remains constant.
iv. The retention ratio, b, once decided upon, is constant
v. growth rate, g = br where b is retention ratio and r is rate of return
vi. Discount rate is greater than the growth rate, ke> br
3. Formula
Market Price = D0( 1 + g)
Ke – g
3.2.3 Modigliani and Miller (MM) Hypothesis
1. Given by : Modigliani and Miller

2. Theory
a. Dividend policy has no effect on its value of assets
b. Assumptions
i. Perfect capital markets and rational investors,
ii. Funds required are raised through equity only
iii. No differences in the tax rates applicable to capital gains and dividends.
iv. Risk of uncertainty does not exist. Investors are able to forecast future prices
v. MM Hypothesis is primarily based on the arbitrage argument
vi. When the firm pays dividends, its advantage is offset by external financing.
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3. Formula
Market Price (P0) =P1 + D1
1 + Ke
Market value of firm = (new shares + old shares)* P 1+Income - Investment)
1 + Ke
3.2.4 Dividend Discount Model
1. The price a share will be traded is calculated by the net present value of all expected future
divided payment and share price discounted by an appropriate risk-adjusted rate
2. Intrinsic Value = Sum of Present Value of Dividends + Present Value of Stock Sale Price
= D1 + D2 + D3 +…….. + ___Pn___
1 2 3
(1 + k) (1 + k) (1 + k) (1 + k)n
3. Dividend Discount Model can have any of the following growth rates
a. Zero-growth
b. Constant-growth(Similar to Gordon Growth Model)
c. Variable-growth model
4. Valuation process
a. During valuation of shares, assuming same growth rate till infinity may not be
appropriate . At the same time, estimating growth rate for every year till infinity is
also not possible. Hence to resolve such a situation following process is adopted.
Estimate growth rate for future years to the extent possible example 12% for 3 years,
11% for next 2 years etc. Assume constant growth rate beyond a certain point.
Example 10% thereafter etc.
b. Steps in solving variable dividend growth rate
Step 1 : Compute dividend for every year based on variable growth rates before it
becomes constant
Step 2 : Compute the terminal value for the dividends at constant rate using Gordon's
formula
Step 3 : Compute the present value of Step 1 and Step 2 to get Value per share
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3.3 Free cash flow-based valuation

1. Meaning
a. Free cash flow (FCF) is a measure of how much cash a business generates after
accounting for capital expenditures such as buildings or equipment.
b. It is amount available with the company after fulfilling commitments such as investment
in capital expenditure and increase in working capital
c. Free cash flow to the firm
i. It is the surplus cash available with the firm without considering the impact of
interest and any cash flow related to debt obligations
ii. FCFF = Net operating income- (Capex +Increase in WC – Depreciation)
d. Free cash flow to the firm
i. It is the surplus cash available with the equity shareholders after considering the
impact of interest and any cash flow related to debt obligations
ii. FCFE = Net income- (Capex +Increase in WC – Depreciation) *Equity
(Equity+Debt)
2. Value for firm
a. It is the value of business from the point of view of long term fund providers without
differentiating between debt and equity.
b. It is used for valuation of business, strategies. Segment etc
c. Value of business (V) = FCFF(1+g)
Ko –g
d. Where Ko is overall cost of capital or WACC
3. Value of equity
a. If is the value of company from the point of view of equity shareholders i.e from owners’
point of view
b. It is used in portfolio management, merges and acquisitions etc
c. Methods of valuation of equity
i. Alternative 1: Value of Equity(E) = FCFE(1+g)
Ke –g
Where Ke is cost of equity
ii. Alternative 2: Value of Equity € = Value of Firm– Value of debt
4. Valuation of Unlisted Companies and Estimating Beta
a. Beta of unlisted companies can be computed based on the concept of proxy beta from
portfolio management
b. Steps in valuation
i. Step I: beta of similar listed companies and compute unlevered beta
Unlevered beta = beta / 1 + (1 - tax rate) x (debt / equity)
ii. Step 2 Adjust accounting policies to determine the correct earnings estimate
iii. Step 3: Compute Cost of equity –This can be done using the CAPM technique
iv. Step 4: Compute WACC rate after considering cost of debt and cost of equity
v. Step 5 : Compute goodwill
vi. Step 6: future cash flows
vii. Step 7 :sum of the PV of the cashflows = value of firm
5. Economic value added
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a. Meaning : Measure of a company's financial performance based on the residual wealth

calculated by deducting cost of capital from its operating profit (adjusted for taxes on a
cash basis). (Also referred to as "economic profit".)
b. Computation
i. EVA = NOPAT – (WACC*CE)
ii. NOPAT = After cash taxes but before financing costs
iii. Capital employed = Debt + Share capital + Reserves and surplus
c. Market value added = Market value of firm (D+E) – Book value of firm(D+E)
d. Shareholders value added = Market value of Equity – Book value of equity
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3.4 Summary chart
Valuation
Meaning Approaches
Asset based Earnings based Cash flow

Measurement
in monetary
terms
Intrinsic value PE Ratio For Shareholder For Entity
Dividend
Enterprise Sales to Price
based FCFF
value ratio
valuation
Earnings
FCFE
capitalization
EV to
EBITDA
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Intrinsic value method •MV of Assets – Liability /No of shares
•Equity + Debt – Cash

Enterprise value
•Operating profit *EV to EBITDA
•EPS*PE ratio = MPS

PE ratio
•PAT*PE Ratio = Equity
Earnings Capitalization •PAT/capitalization factor
One time cash flow •CF*DF
Recurring CF •CF*AF
Constant Growth CF •CF1/k-g
Variable growth cash flow(applies for dividend discount model also)
Year CF DF DCF
1 CF1 DF1
2 CF2 DF2
3 CF3 DF3
4 onwards CF4 onwards DF3
TV3 = CF4
K–g
Value of Asset
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DIVIDEND BASED VALUATION
Distribution of
profits to SH
Meaning
Similar to
Negative Impact
drawings by
immediately
partner
On Price Ex-Dividend
Reduced price
Price
Ex-Dividend
On
Date
Impact
Dividends
Subjective Walter Model
On Value
Dividend Gordon Growth
theories model
On FV Dividend % M-M Approach
Dividend Payout
Computation On EPS
ratio
On MPS Dividend Yield
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Walter Approach
1. Formula
Market price = DPS + Ra (EPS- DPS)
Rc .
Rc
Where Ra is return on investment
and Rc is overall cost of capital
2. If Ra<Rc, Optimum pay out is 100%, if Ra > Rc , optimum pay out is 0%
Gordon Growth Model

Formula
Market Price = D0( 1 + g)
Ke – g
g = b *r
Modigliani and Miller (MM) Hypothesis

Formula
Market Price (P0) =P1 + D1
1 + Ke
Market value of firm = (new shares + old shares)* P 1+Income - Investment)
1 + Ke
DCF/FCFE valuation
FCF valuation
Meaning Types
Profits FCFF Based FCFE Based
CF=Net operating CF=Net income -

income (Capex +Incre in WC –Depn)*Equity
+Depn
- (Capex +Increase in (Equity + Debt)
-Increase in WC WC – Depreciation)
- Capex
Value of Equity =
Value of firm = FCFE0(1+g)
FCFF0(1+g)
ke-g
ko-g
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Last Projected
FY
Year1 Year2 Year3 Year4
onwards
Sales
Less COGS
Less :
Operating exp
EBIT
Less Tax
EAT
Add Depn
Less Inc in WC
Less Cap Ex
FCFF FCFF1 FCFF2 FCFF3 TV3= FCFF4
K-g
DF DF1 DF2 DF3 DF3
DCF PV1 PV2 PV3 PV3
Total Value of
DCF= firm
Economic Value Added
EVA
=
Expected
Actual Profit -
Profit
NOPAT CE*WACC
EBIT(1-t) CE = E+D WACC
Or Kd = Intest*(1-t)
PAT+Interest(1-t) Ke= CAPM
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3.5 Problems
Problem No 1. Book value method
Calculate value per share from the following details
Particulars Amount (Rs)

1,000, 5% Preference Shares of Rs. 100 each fully paid Rs. 1,00,000
2,000 Equity Shares of Rs. 100 each fully paid Rs. 2,00,000
Reserve and Surplus Rs. 2,00,000
6% Debentures Rs.1,00,000
Current Liabilities Rs. 1,00,000
Assets:
Fixed Assets Rs.4,00,000
Current Assets Rs. 3,00,000
For the purpose of valuation, fixed assets and current assets are to be depreciated by 10% ; Interest on
debentures is due for six months; preference dividend is due for the year. Neither of these has been
provided so.
Calculate the value of each equity share under Net Asset Method.
(Answer Hint :Rs 161 )
Problem No 2. Valuation based on risk premium RTP May 2017, MTP November 2018
Capital structure of Sun Ltd., as at 31.3.2003 was as under:

(Rs in lakhs)
Equity share capital 80
8% Preference share capital 40
12% Debentures 64
Reserves 32
Sun Ltd., earns a profit of Rs 32 lakhs annually on an average before deduction of incometax, which
works out to 35%, and interest on debentures.
Normal return on equity shares of companies similarly placed is 9.6% provided:

(a) Profit after tax covers fixed interest and fixed dividends at least 3 times.
(b) Capital gearing ratio is 0.75.
(c) Yield on share is calculated at 50% of profits distributed and at 5% on undistributed profits.
Sun Ltd., has been regularly paying equity dividend of 8%.
Compute the value per equity share of the company.
ANALYZE the value per equity share of the company assuming the risk premium as:
(A) 1% for every one time of difference for Interest and Fixed Dividend Coverage.
(B) 2% for every one time of difference for Capital Gearing Ratio.
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(Answer Hint : Rs 40.65 )
Problem No 3. Business valuation November 2016(8 Marks)
XN Ltd. reported a profit of Rs 100.32 lakhs after 34% tax for the financial Year 2015-2016. An
analysis of the accounts reveals that the income included extraordinary items of Rs 14 lakhs and an
extraordinary loss of Rs 5 lakhs. The existing operations, except for the extraordinary items, are
expected to continue in future. Further, a new product is launched and the expectations are as under:
Particulars Amount Rs in lakhs

Sales 70
Material Costs 20
Labour Costs 16
Fixed Costs 10
The company has 50,00,000 Equity Shares of Rs 10 each and 80,000, 9% Preference Shares of Rs 100
each with P/E Ratio being 6 times.
You are required to:

(i) compute the value of the business. Assume cost of capital to be 12% (after tax) and
(ii) determine the market price per equity share.
(Answer Hint : Value of Business (Rs110.22/0.12) 918.50 lakhs , Market price per shareRs 12.36 )
Problem No 4. EV to EBITA multiple
Data given below is extract financials of a company for the year ended 31-3-2019. Compute EV to
EBITDA ratio.
Particulars Rs
1 Revenue from operations (net) 50,00,000
2 Other income -
3 Total revenue (1+2) 50,00,000
4 Expenses
(a) Cost of materials consumed 1,20,000
(b) Purchases of stock-in-trade 18,00,000
(c) Changes in inventories of finished goods, 2,00,000
work-in-progress and stock-in-trade
(d) Employee benefits expense 5,00,000
(e) Finance costs 10,00,000
(f) Depreciation and amortisation expense 5,00,000
(g) Other expenses 4,80,000
Total expenses 46,00,000
5 Profit / (Loss) before exceptional and 4,00,000

extraordinary items and tax (3 - 4)
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6 Exceptional items 28.a 5,00,000
7 Profit / (Loss) before extraordinary items and tax 9,00,000

(5 + 6)
8 Extraordinary items 28.b 1,00,000
9 Profit / (Loss) before tax (7 + 8) 10,00,000
10 Tax expense:
(a) Current tax expense for current year 3,00,000
(b) (Less): MAT credit (where applicable) -
(c) Current tax expense relating to prior years -
(d) Net current tax expense 3,00,000
(e) Deferred tax -
3,00,000
11 Profit / (Loss) from continuing operations (9 +10) 7,00,000
Balance sheet
Particulars Note ₹
Equity and liabilities
I Shareholders funds
Share capital(30,000 shares of Rs.10 Each) 3,00,000
Reserves and surplus 60,00,000
II Non-Current liabilities
Long term borrowings 21,40,000
III Current liabilities
Trade payables 10,20,000
Provisions 18,40,000
1,13,00,000
Assets
I Non-Current assets
PPE 24,00,000
Intangible 3,00,000
Non-Current investments
II Current Assets
Inventories 24,60,000
Trade receivables 49,20,000
Cash and cash equivalent 12,20,000
1,13,00,000
Market price per share is Rs.250 on the above date.
(Answer Hint : 5.94 times )
7
Problem No 5. Chop-Shop approach MTP November 2016, MTP November 2018
Using the chop-shop approach (or Break-up value approach), assign a value for Cranberry Ltd. whose
stock is currently trading at a total market price of €4 million. For Cranberry Ltd, the accounting data
set forth three business segments: consumer wholesale, retail and general centers. Data for the firm’s
three segments are as follows
Business Segment Segment Sales Segment Assets Segment Operating Income
Wholesale € 2,25,000 € 6,00,000 € 75,000
Retail € 7,20,000 € 5,00,000 € 1,50,000
General € 25,00,000 € 40,00,000 € 7,00,000
Industry data for “pure-play” firms have been compiled and are summarized as follows:
Business Segment Capitalization/Sales Capitalization/Assets Capitalization/Operating Income

Wholesale 0.85 0.7 9
Retail 1.2 0.7 8
General 0.8 0.7 4
(Answer Hint : 3766750)
Problem No 6. Valuation with valuation multiples November 2019(O)(5 Marks), MTP

November 2021
XY Ltd., a Cement manufacturing Company has hired you as a financial consultant of the company.
The Cement Industry has been very stable for some time and the cement companies SK Ltd. & AS
Ltd. are similar in size and have similar product market mix characteristic. Use comparable method to
value the equity of XY Ltd. In performing analysis, use the following ratios:
(i) Market to book value

(ii) Market to replacement cost
(iii) Market to sales
(iv) Market to Net Income
The following data are available for your analysis:
(Amount in Rs) SK Ltd. AS Ltd. XY Ltd.

Market Value 450 400
Book Value 400 300 250
Replacement Cost 600 550 500
Sales 550 450 500
Net Income 18 16 14
(Answer Hint : Value of XY Ltd. according to the comparable method is Rs 363.31)

Problem No 7. Walter model and Gordons’ model
May 2011(8 Marks),RTP November 2020(O)
The following information is given for QB Ltd.

• Earning per share Rs. 12,
• Dividend per share Rs. 3,
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• Cost of capital 18%,,

• Internal Rate of Return on investment 22%,
• Retention Ratio 40%.
Calculate the market price per share using Gordon’s formula and Walter’s formula
(Answer Hint : (i) Gordons Formula = 78.26, (ii) Walter Formula = 77.77
Alternative Solution : (i) Gordons Formula = 200, (ii) Walter Formula = 77.77)
Problem No 8. M&M Model May 2018(O)(8 Marks)
CBZ limited belongs to a risk class for which the approved capitalization rate is 10%. It currently has
outstanding 6,000 shares selling at Rs100/- each. The firm is planning for declaration of dividend of
Rs 6/- per share at the end of the current financial year. The company expects to have a net income of
Rs 60,000/- and has a proposal to make new investments of Rs1,50,000/-. As under the M-M
hypothesis the payment of dividend doesn't affect the value of the firm, calculate price of share at the
end of financial year, no. of shares to be issued and value of firm separately in the following situations
:
(i) When dividends are paid and
(ii) When dividends are not paid.
(Answer Hint : When dividend is paid: P1 = 104, Number of additional shares to be issued 1212
shares, When dividend is not paid: P1 = 110, Number of additional shares to be issued 818 shares)
Problem No 9. Multi- Period dividend discount model
Z Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The growth rate is likely to
fall to 10% for the third year and fourth year. After that the growth rate is expected to stabilize at 8%
per annum. If the last dividend paid was Rs. 1.50 per share and the investors’ required rate of return is
16%, find out the intrinsic value per share of Z Ltd. as of date.
You may use the following table:
Years 0 1 2 3 4 5
Discounting Factor at 16% 1 0.86 0.74 0.64 0.55 0.48
Problem No 10. Multiple period dividend discount with EPS November 2019(O)(8 Marks),
MTP June 2021
You are interested in buying some equity stocks of RK Ltd. The company has 3 divisions operating in
different industries. Division A captures 10% of its industries sales which is forecasted to be Rs 50
crore for the industry. Division B and C captures 30% and 2% of their respective industry's sales,
which are expected to be Rs 20 crore and Rs 8.5 crore respectively. Division A traditionally had a 5%
net income margin, whereas divisions B and C had 8% and 10% net income margin respectively. RK
Ltd. has 3,00,000 shares of equity stock outstanding, which sell at Rs 250
7
The company has not paid dividend since it started its business 10 years ago. However, from the
market sources you come to know that RK Ltd. will start paying dividend in 3 years time and the pay-
out ratio is 30%. Expecting this dividend, you would like to hold the stock for 5 year. By analysing
the past financial statements, you have determined that RK Ltd.'s required rate of return is 18% and
that P/E ratio of 10 for the next year and on ending P/E ratio of 20 at the end of the fifth year are
appropriate.
Required:
(i) Would you purchase RK Ltd. equity at this time based on your one year forecast?
(ii) If you expect earnings to grow @ 15% continuously, how much are you willing to pay for the
stock of RK Ltd ?
Ignore taxation.
PV factors are given below :
Years 1 2 3 4 5
PVIF@ 18% 0.847 0.718 0.609 0.516 0.437
(Answer Hint : (i) Market Price based on One Year ForecastRs 210.90 (ii) Rs 271.83 )
Problem No 11. Dividend model for decision making Practice Manual(Old)
The Beta Co-efficient of Target Ltd. is 1.4. The company has been maintaining 8% rate of growth in
dividends and earnings. The last dividend paid was Rs. 4 per share. Return on Government securities
is 10%. Return on market portfolio is 15%. The current market price of one share of Target Ltd. is Rs.
36.
(i) What will be the equilibrium price pr share of Target Ltd.?

(ii) Would you advise purchasing the share?
(Answer Hint : (i) 48 (ii) Recommended to buy )
Problem No 12. Dividend valuation and income statement November 2012(8 Marks)
Following Financial Data for Platinum Ltd. are available:
For the year 2011:

Particulars (Rs In lakhs)
Equity Shares (Rs 10 each) 100
8% Debentures 125
10% Bonds 50
Reserve and Surplus 200
Total Assets 500
Assets Turnover Ratio 1.1
Effective Tax Rate 30%
Operating Margin 10%
Required rate of return of investors 15%
Dividend payout ratio 20%
Current market price of shares Rs13
7

(i) Draw income statement for the year
(ii) Calculate the sustainable growth rate
(iii) Compute the fair price of the company's share using dividend discount model, and
(iv) Draw your opinion on investment in the company's share at current price.
(Answer Hint : (i) Retained Earnings 22.40 (ii) SGR = 0.0933(1 - 0.20) = 7.47% (iii) Rs8.00 (iv)
Since the current market price of share is Rs13.00, the share is overvalued. Hence the investor should
not invest in the company)
Problem No 13. Value of share from FCFE and CAPM May 2016(5 Marks)
Calculate the value of share of Avenger Ltd. from the following information:
• Equity capital of company Rs 1,200 crores
• Profit of the company Rs 300 crores
• Par value of share Rs 40 each
• Debt ratio of company 25%
• Long run growth rate of the company 8%
• Beta 0.1; risk free interest rate 8.7%
• Market returns 10.3%
• Change in working capital per share Rs 4
• Depreciation per share Rs 40
• Capital expenditure per share Rs 48
Problem No 14. Rectification of valuation November 2014(6 Marks),RTP May 2019
The valuation of Hansel Limited has been done by an investment analyst. Based on an expected free
cash flow of Rs 54 lakhs for the following year and an expected growth rate of 9 percent, the analyst
has estimated the value of Hansel Limited to be Rs 1800 lakhs. However, he committed a mistake of
using the book values of debt and equity. The book value weights employed by the analyst are not
known, but you know that Hansel Limited has a cost of equity of 20 percent and post tax cost of debt
of 10 percent. The value of equity is thrice its book value, whereas the market value of its debt is
nine-tenths of its book value.
What is the correct value of Hansel Ltd?
(Answer Hint : Rs 974.73 lakhs.)
Problem No 15. Rectification of valuation November 2014(6 Marks),RTP May 2019
The valuation of Hansel Limited has been done by an investment analyst. Based on an expected free
cash flow of Rs 54 lakhs for the following year and an expected growth rate of 9 percent, the analyst
has estimated the value of Hansel Limited to be Rs 1800 lakhs. However, he committed a mistake of
using the book values of debt and equity. The book value weights employed by the analyst are not
known, but you know that Hansel Limited has a cost of equity of 20 percent and post tax cost of debt
of 10 percent. The value of equity is thrice its book value, whereas the market value of its debt is
nine-tenths of its book value.
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What is the correct value of Hansel Ltd?
(Answer Hint : Rs 974.73 lakhs.)
Problem No 16. Basic problem on EVA May 2018(N)(5 Marks)
Herbal World is a small, but profitable producer of beauty cosmetics using the plant Aloe Vera.
Though it is not a high-tech business, yet Herbal's earnings have averaged around Rs 18.5 lakh after
tax, mainly on the strength of its patented beauty cream to remove the pimples.
The patent has nine years to run, and Herbal has been offered Rs 50 lakhs for the patent rights.
Herbal's assets include Rs 50 lakhs of property, plant and equipment and Rs 25 lakhs of working
capital. However, the patent is not shown in the books of Herbal World. Assuming Herbal's cost of
capital being 14 percent, calculate its Economic Value Added (EVA).
(Answer Hint : = Rs 1 lac)
Problem No 17. EVA with Replacement cost RTP November 2011,RTP May 2015
ABC Ltd. has divisions A,B & C. The division C has recently reported on annual operating profit of
Rs 20,20,00,000. This figure arrived at after charging Rs 3 crores full cost of advertisement
expenditure for launching a new product. The benefits of this expenditure is expected to be lasted for
3 years.
The cost of capital of division C is Rs 11% and cost of debt is 8%.
The Net Assets (Invested Capital) of Division C as per latest Balance Sheet is Rs 60 crore, but
replacement cost of these assets is estimated at Rs 84 crore.
You are required to compute EVA of the Division C.
(Answer Hint : Rs 12.96 crore.)
Problem No 18. EVA with leverage ratio

RTP May 2011,, MTP November 2014, MTP November 2016
Calculate Economic Value Added (EVA) with the help of the following information of Hypothetical
Limited:
Financial leverage : 1.4 times

Capital structure : Equity Capital Rs. 170 lakhs
Reserves and surplus Rs. 130 lakhs
10% Debentures Rs. 400 lakhs
Cost of Equity : 17.5%
Income Tax Rate : 30%.
(Answer Hint : Rs. 17.5 lakhs)
Problem No 19. Value of rights RTP May 2014,RTP November 2018
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ABC Limited’s shares are currently selling at Rs 13 per share. There are 10,00,000 shares
outstanding. The firm is planning to raise Rs 20 lakhs to Finance a new project.
Required:
What are the ex-right price of shares and the value of a right, if
(i) The firm offers one right share for every two shares held.
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholders’ wealth change from (i) to (ii)? How does right issue increases
shareholders’ wealth?
(Answer Hint : Value of Right. Rs 3 Rs 1, Thus, there will be no change in the wealth of shareholders
from (i) and (ii).)
Problem No 20. Buy back November 2018(O)(5 Marks), MTP June 2021
Eager Ltd. has a market capitalization of Rs 1,500 crores and the current market price of its share is
Rs 1,500. It made a PAT of 200 crores and the Board is considering a proposal to buy back 20% of
the shares at a premium of 10% to the current market price. It plans to fund this through a 16% bank
loan.
You are required to calculate the post buy back Earnings Per Share (EPS). The company's corporate
tax rate is 30%.
(Answer Hint : Rs 203.80 )
Problem No 21. Bonus with promotor holding May 2018(O)(8 Marks)
Intel Ltd., promoted by a Trans National Company, is listed on the stock exchange.
The value of the floating stock is Rs 45 crores. The Market Price per Share (MPS) is Rs 150.
The capitalisation rate is 20 percent.
The promoters holding is to be restricted to 75 per cent as per the norms of listing requirement. The
Board of Directors have decided to fall in line to restrict the Promoters’ holding to 75 percent by
issuing Bonus Shares to minority shareholders while maintaining the same Price Earnings Ratio (P/E).
You are required to calculate:

(i) Bonus Ratio;
(ii) MPS after issue of Bonus Shares; and
(iii) Free float Market capitalisation after issue of Bonus Shares
(Answer Hint assmung promotor holding of 80% : Bonus 10 lacs for 30 lacs i.e. 1 shares for 3 shares
held., Market Price After Bonus Issue = Rs 28.125 x 5 = Rs 140.63, Free Float Capitalization after
Bonus Issue 56.252 crore )
Problem No 22. Gordon model November 2020(O)(5 Marks)
Sandy Ltd. has a book value per share of Rs 140.00. Its return on equity is 16% and follows a policy
of retaining 60 percent of its annual earnings. What is the price of its share now if the opportunity cost
of capital is 18 percent?
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[Adopt perpetual growth model to arrive at the solution].
Problem No 23. EVA November 2020(O)(5 Marks)
Herbal Box is a small but profitable producer of beauty cosmetics using the plant Aloe Vera. Though
it is not a high-tech business, yet Herbal’s earnings have averaged around Rs 18.5 lakhs after tax,
mainly on the strength of its patented beauty cream to remove the pimples.
The patent has nine years to run, and Herbal Box has been offered Rs 50 lakhs for the patent rights.
Herbal’s assets include Rs 50 lakhs of property, plant and equipment, and Rs 25 lakhs of working
capital. However, the patent is not shown on the books of Herbal Box. Assuming Herbal’s cost of
capital being 14 percent, calculate its Economic Value Added (EVA).
Problem No 24. Reverse dividend calculation July 2021(O)(5 Marks)
NM Ltd. (NML) is aspiring to enter the capital market in a three years' time. The Board wants to
attain the target price of Rs 70 for its shares at the end of three years. The present value of its shares is
Rs 52.03. The dividend is expected to grow at a rate of 15% for the next three years. NML uses
dividend growth model for its projections.
The required rate of return is 15%.
You are required to calculate the amount of dividend to be declared by the board in the base year so as
to achieve the target price.
Period (t) 1 2 3
PVIF (15%, t) 0.8696 0.7561 0.6575
Problem No 25. Buy Back July 2021(O)(12 Marks)
SM Limited has a market capitalization of Rs 3,000 crore and the current earnings per share (EPS) is
Rs 200 with a price earnings ratio (PER) of 15. The Board of directors is considering a proposal to
buy back 20% of the shares at a premium which can be supported by the financials of the company.
The Boards expects post buy back market price per share (MPS) of Rs 3057. Post buy back PER will
remain same. The company proposes to fund the buy back by availing 8% bank loan since available
resources are committed for expansion plans.
Applicable income tax rate is 30%.

You are required to calculate :
(i) The interest amount which can be paid for availing the bank loan,
(ii) The loan amount to be raised and
(iii) The premium per share and percentage premium paid. over the current MPS.
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SECURITY ANALYSIS
Marks distribution
7
4.1 Basics
1. 'Securities': “securities” include shares, scrips, stocks, bonds, debentures, debenture stock or other
marketable securities of a like nature in or of any incorporated company or other body corporate;
2. Securities Market: Securities Markets is a place where buyers and sellers of securities can trade.
Transctions can be done only through broker (membet of market)
3. Parties to securities transaction
a. Buyer
b. Seller
c. Broker (Member of securities market)
4. Trading process
a. Order
b. Trade
c. Settlement
5. Types of prices
a. Open price
b. High price
c. Low price
d. Close price
6. Type of securities
a. Equity shares
b. Debt instruments
c. Mutual funds
d. Derivatives
4.2 Other terms

1. DEMAT form: DEMAT accounts allow for electronic transactions when shares of stock are
bought and sold. Within a DEMAT account, the certificates for stocks and other securities of the
user are held as a means for seamless trades to be made.
2. Trading settlement: This refers to the process of transactions involved in buying/selling of
securities in the market.
3. T+2 Rolling Settlement:
a. Meaning: Indian stock market follows T+2 rolling settlement which means, from the
trade date to settlement date, there will be gap of 2 working days. Details are as follows.
b. Trading settlement – Buy T+2 Rolling Settlement
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Shareholder
Receive
share Place order and
make payment
Broker
Share khan Sharekhan,
SBICAP
Delivers Makes
shares payment
Clearing house
4. Trading settlement – Sell T+2 Rolling Settlement
Shareholder
Receive money Place order and deliver

shares
Broker
Share khan Sharekhan,
SBICAP
Makes payment Deliver shares
Clearing house
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4.3 Security Analysis

1. Meaning: Security Analysis involves a systematic analysis of the risk return profiles of various
securities which is to help a rational investor to estimate a value for a company from all the price
sensitive information/data so that he can make purchases when the market under-prices some of
them and thereby earn a reasonable rate of return
2. Fundamental Analysis
a. Meaning : The value of a share, according to a fundamental analyst, depends on
performance of company only . A share that is priced below the above value must be
bought, while a share quoting above the value must be sold
b. Factors considered
i. Economic Analysis : Growth Rates -National Income, Growth Rates of Industrial
Sector, Inflation
ii. Industry Analysis: Nature of industry, Size of industry, Product Life-Cycle etc
iii. Company Analysis: Management priorities and plans, Sources and Uses of
Funds, Growth Record etc
c. Valuation methods
i. Intrinsic value/book value
ii. Earnings yield method
iii. Fair value method
iv. Dividend discount model
v. Discounted cash flow/Free cash Flow to Equity method(DCF or FCFE)
3. Technical Analysis
a. Meaning: Technical analysis is a method of evaluating securities by analyzing the
statistics generated by market activity.
b. Assumptions:
i. the market discounts everything,
ii. price moves in trends and
iii. history tends to repeat itself.
c. Trends
i. One of the most important concepts in technical analysis is that of a trend, which
is the general direction that a security is headed
ii. Support is the price level through which a stock or market seldom falls.
iii. Resistance is the price level that a stock or market seldom surpasses.
iv. Volume is the number of shares or contracts that trade over a given period of
time, usually a day. The higher the volume, the more active the security.
d. Charts
i. Technicians believe that all the information they need about a stock can be found
in its charts
ii. There are four main types of charts used by investors and traders: line charts, bar
charts, candlestick charts and point and figure charts.
e. Other patterns
i. A head and shoulders pattern is reversal pattern that signals a security is likely to
move against its previous trend.
ii. A cup and handle pattern is a bullish continuation pattern in which the upward
trend has paused but will continue in an upward direction once the pattern is
confirmed.
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iii. Double tops and double bottoms are formed after a sustained trend and signal to
chartists that the trend is about to reverse. The pattern is created when a price
movement tests support or resistance levels twice and is unable to break through.
iv. A triangle is a technical analysis pattern created by drawing trendlines along a
price range that gets narrower over time because of lower tops and higher
bottoms. Variations of a triangle include ascending and descending triangles.
v. Flags and pennants are short-term continuation patterns that are formed when
there is a sharp price movement followed by a sideways price movement.
vi. The wedge chart pattern can be either a continuation or reversal pattern. It is
similar to a symmetrical triangle except that the wedge pattern slants in an
upward or downward direction.
vii. A moving average is the average price of a security over a set amount of time.
There are three types: simple, linear and exponential. Moving averages help
technical traders smooth out some of the noise that is found in day-to-day price
movements, giving traders a clearer view of the price trend.
4. Movement theories
a. The Dow Theory:
i. The Dow Theory is based upon the movements of two indices, constructed by
Charles Dow, Dow Jones Industrial Average (DJIA) and Dow Jones
Transportation Average (DJTA).
ii. These averages reflect the aggregate impact of all kinds of information on the
market.
iii. The movements of the market are divided into three classifications, all going at
the same time;
1. the primary movement,
2. the secondary movement, and
3. the daily fluctuations.
iv. The primary movement is the main trend of the market, which lasts from one year
to 36 months or longer. This trend is commonly called bear or bull market.
v. The secondary movement of the market is shorter in duration than the primary
movement, and is opposite in direction. It lasts from two weeks to a month or
more.
vi. The daily fluctuations are the narrow movements from day-to-day.
b. Random walk theory

i. Stocks take a random and unpredictable path
ii. The theory that stock price changes are independent of each other
iii. So the past movement or trend of a stock price or market cannot be used to
predict its future movement.
iv. The random walk theory corresponds to the belief that markets are efficient, and
that it is not possible to beat or predict the market because stock prices reflect all
available information and the occurrence of new information is seemingly
random as well.
v. The random walk theory is in direct opposition to technical analysis
c. Efficient Market Theory (Efficient Market Hypothesis)
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i. As per this theory, at any given time, all available information is fully reflected in
securities' prices. Thus this theory implies that no investor can consistently
outperform the market as every stock is appropriately priced based on available
information.
ii. Level of Market Efficiency
1. Weak form efficiency – Price reflect all information found in the record
of past prices and volumes.
2. Semi – Strong efficiency – Price reflect not only all information found in
the record of past prices and volumes but also all other publicly available
information.
3. Strong form efficiency – Price reflect all available information public as
well as private.
d. Empirical Evidence/Process- Serial Correlation Test, Run Test:, Filter Rules Test
Steps in applying t test hypothesis

Steps Parameter Calculation
Step 1 Compute Mean 2𝑛1 𝑛2
𝜇= +1
𝑛1 + 𝑛2
Where n1 is number of positive signs and n2
is negative signs
Step 2 Compute S.D
2𝑛1 𝑛2 (2𝑛1 𝑛2 − 𝑛1− 𝑛2 )
𝜎=√
(𝑛1 + 𝑛2 )2 (𝑛1 + 𝑛2 − 1)
Step 3 Compute Interval 𝜇±𝑡×𝜎
where t is t distribution value at n-1 degrees
of freedom
Step 4 Compute N N is no of test runs
Step 5 Conclusion If N is within the above limit, then market
exhibits weak form
If N is outside the limit, market don’t exhibit
weak form
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4.4 Summary chart
Securities market
Parties Price discovery Type of Pre- open

Meaning Timing
involved Process prices market
Supply
Buyer Start 9.15 Open Starts 9.00
curve
Place where
securities are
bought and
sold
Demand
Seller Ends at 3.30 High Ends at 9.15
curve
Broker Low
Intersection point is
Equilibrium Price
Close
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4.5 Problems
Problem No 1. Simple moving average
From the data given below compute 5 day moving average
Day Nifty
1 9000
2 9041
3 8947
4 8940
5 8966
6 8895
7 8944
8 8883
9 8929
10 8895
11 8858
12 8835
13 8832
14 8893
15 8829
(Answer Hint : Rs 8978.8,Rs 8957.8,Rs 8938.4,Rs 8925.6,Rs 8923.4,Rs 8909.2,Rs 8901.8,Rs 8880,Rs
8869.8,Rs 8862.6,Rs 8849.4 )
Problem No 2. Exponential moving average

November 2009(6 Marks), RTP May 2017, MTP November 2017, MTP May 2018
Closing values of BSE Sensex from 6th to 17th day of the month of January of the year 200X were as
follows:
Days Date Day Sensex

1 6 THU 14522
2 7 FRI 14925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 15222
6 11 TUE 16000
7 12 WED 16400
8 13 THU 17000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 18000
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Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30 days
simple moving average of Sensex can be assumed as 15,000. The value of exponent for 30 days EMA
is 0.062.
(Answer Hint : Rs 14970.364,Rs 14967.55,Rs 14983.32,Rs 15046.354,Rs 15130.28,Rs 15246.203,Rs

15416.938 )
Problem No 3. Exponential moving average November 2019(N)(8 Marks)
Closing values of BSE Sensex from 6th to 17th day of the month of January of the year 20xx were as
follows
Days Date Day Sensex

1 6 THU 34522
2 7 FRI 34925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 35222
6 11 TUE 36000
7 12 WED 36400
8 13 THU 37000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 38,000
Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30 days
simple moving average of Sensex can be assumed as 35,000. The value of exponent for 30 days EMA
is 0.064. Provide analyzed conclusion on the basis of your calculation s.
(Calculations should be up to three decimal points.)
(Answer Hint : Rs 34969.408,Rs 34966.566,Rs 34982.914,Rs 35048.008,Rs 35134.535,Rs

35253.925,Rs 35429.674)
Problem No 4. Efficient Market Hypothesis RTP May 2019
The directors of Implant Inc. wishes to make an equity issue to finance a $10 m (million) expansion
scheme which has an excepted Net Present Value of $2.2m and to re-finance an existing $6 m 15%
Bonds due for maturity in 5 years time. For early redemption of these bonds there is a $3,50,000
penalty charges. The Co. has also obtained approval to suspend these pre-emptive rights and make a
$15 m placement of shares which will be at a price of $0.5 per share. The floatation cost of issue will
be 4% of Gross proceeds. Any surplus funds from issue will be invested in IDRs which is currently
yielding 10% per year.
The Present capital structure of Co. is as under:

$’000
Ordinary Share ($1 per share) 7,000
Share Premium 10,500
Free Reserves 25,500
43,000
7
15% Term Bonds 6,000

11% Debenture (2012-2020) 8,000
57,000
Current share price is $2 per share and debenture price is $ 103 per debenture. Cost of capital of Co. is
10%. It may be further presumed that stock market is semi-strong form efficient and no information
about the proposed use of funds from the issue has been made available to the public.
You are required to calculate expected share price of company once full details of the placement and
to which the finance is to be put, are announced.
(Answer Hint : Expected market value $0.848 )
Problem No 5. Empirical evidence January 2021(8 Marks)
Mr. X is of the opinion that market has recently shown the Weak Form of Market Efficiency. In order
to test the validity of his impression he has collected the following data relating to the movement of
the SENSEX for the last 20 days.
Days Open High Low Close

1 33470.94 33513.79 33438.03 33453.99
2 33453.64 33478.11 33427.82 33434.83
3 33414.06 33440.29 33397.65 33431.93
4 33434.94 33446.18 33377.78 33383.41
5 33372.92 33380.27 33352.12 33370.93
6 33375.85 33389.49 33331.42 33340.75
7 33340.89 33340.89 33310.95 33330.98
8 33326.84 33340.91 33306.17 33335.08
9 33307.16 33328.22 33296.43 33301.97
10 33298.64 33318.60 33254.28 33259.03
11 33260.04 33228.85 33241.66 33251.53
12 33255.92 33289.46 33249.46 33285.89
13 33288.86 33535.67 33255.98 33329.28
14 33335.00 33346.21 33276.72 33284.17
15 33293.83 33310.86 33278.54 33298.78
16 33300.02 33337.79 33300.02 33325.38
17 33323.36 33356.34 33322.44 33329.95
18 33322.81 33345.98 33317.44 33319.67
19 33317.51 33321.18 33294.19 33302.32
20 33290.86 33324.96 33279.62 33319.61
You are required: To test the Weak Form of Market Efficiency using Auto-Correlation test, taking
time lag of 10 days.
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PORTFOLIO MANAGEMENT
Marks distribution
7
5.1 Meanings of portfolio management

1. A portfolio refers to a collection of investment tools such as stocks, shares, mutual funds, bonds,
cash and so on depending on the investor’s income, budget and convenient time frame.
2. Portfolio management is the art and science of selecting and overseeing a group of investments
that meet the long-term financial objectives and risk tolerance of a client, a company, or an
institution
3. Main objective of portfolio management is to maximum returns and minimize risk associated with
it.
4. Types Of Portfolio Management
a. Active Portfolio Management: The aim of the active portfolio manager is to make better
returns than what the market dictates. Those who follow this method of investing are
usually contrarian in their approach. Active managers buy stocks when they are
undervalued and start selling when they climb above the norm. Active portfolio
management involves the quantitative analysis of companies to determine the cost of
stock in relation to its potential. To do this, the active manager shuns the efficient market
hypothesis and instead relies on ratios to support his claim.
b. Passive Portfolio Management: At the opposite end of active management comes the
passive investing strategy. Those who subscribe to this theory believe in the efficient
market hypothesis. The claim is that the fundamentals of a company will always be
reflected in the price of the stock. Therefore, the passive manager prefers to dabble in
index funds and ETFs which have a low turnover, but good long-term worth.
5. Portfolio Manager
a. An individual who understands the client’s financial needs and designs a suitable
investment plan as per his income and risk taking abilities is called a portfolio manager. A
portfolio manager is one who invests on behalf of the client.
b. A portfolio manager counsels the clients and advises him the best possible investment
plan which would guarantee maximum returns to the individual.
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5.2 Basics of return and risk

1. Returns
a. Types
i. Securities returns
ii. Portfolio returns
iii. Market returns
b. Formulae
𝑃1 −𝑃0 +𝐷1
i. Returns for a year = 𝑃0
× 100
∑𝑥
ii. Returns based on various years ,𝑥̅ = 𝑛
iii. Return using probability, 𝑥̅ = ∑ 𝑥𝑝
iv. Portfolio return : weighted average,
∑ 𝑥𝑤
1. 𝑥̅ = ∑𝑤
𝑜𝑟
2. Rp= 𝑅1 𝑤1 + 𝑅2 𝑤2+…
2. Types of risk
a. Types
i. Securities risk
ii. Portfolio risk
iii. Market risk
b. Formulae
i. Risk is measured by standard deviation (𝜎)
ii. It is the average length of deviation from mean
iii. Formulae
(𝑥−𝑥̅ )2
1. 𝜎 = √ 𝑛
2. 𝜎 = √∑(𝑥 − 𝑥̅ )2 × 𝑃
c. Applications
i. Standard deviation can positive or negative. It is used for expression of range
from average. i.e for example expectation of stock return is Average + SD(x +
𝜎)
ii. Variance:
1. Variance=𝜎 2
2. It is the Average area of deviation from mean
3. Used for simplifications
3. Stock market Index

a. Meaning: It is notional portfolio of various companies with notional investments whose
objective is to reflect overall return of market. Index in general is representative in nature
to reflect the movements on an average. Stock Market Index will provide the data on
movements on stocks within the index on an average.
b. Examples: Nifty comprises of 50 top companies in NSE, Sensex comprise of 30 companies
in BSE
c. Types
i. General Index like Nifty
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ii. Sector Index like Bank Nifty

iii. Thematic index like High divided yield Index
iv. Calculation: Index Points Today= Market value today * Index previous day
Market value previous day
4. Correlation and regression
a. Meaning: Correlation (r) co-efficient is a measure of nature and strength of association
between two variables. It is measured by r called as correlation co-efficient .
b. Interpretation: If r is positive then variables are likely to move in same direction. If r is
negative then variables are likely to move in opposite direction. If r is 0, then variables are
likely to be independent. Similar when r is high value, chances are high. And when r is less
changes are less. For example, If r = 0.85, then it implies there is 85% chance variables
move in same direction.
c. If r = -0.75, then it implies there is 75% chance that variables move in opposite direction.
d. Range of values :
i. r can take value between -1 and +1
ii. -1 is perfect negative correlation
iii. +1 is perfect positive correlation
e. Correlation is only a measure of probability in direction of movements and not its
proportion of movements. Correlation can’t be for predictions or estimations
5. Regression line
a. Meaning: Regression line is a line draw by way of best fit which passes through various
points under observation between two variables. It is representative of regression equation
between two variables which is used for estimations and projections
b. Why regression
i. Correlation tells you if there is an association between x and y but it doesn’t
describe the relationship or allow you to predict one variable from the other. To do
this we need REGRESSION!
ii. It is measure of average relationship between two variables. Any relationship in
mathematics requires an equation like y = x+2.
iii. When a simple equation represented in graph, it results in a straight line. Hence it
is called are regression line.
iv. Using regression line, predictions are possible where one variable is independent
and another variable is dependent.
c. Regression line is given by
i. Y = a + b X
1. b = r * SD of y
SD of x
2. a = y – (b x)
ii. Where
1. X is independent variable
2. Y is dependent variable
3. b is called as slope
4. a is called as y intercept.
iii. Nature of linear relationship
1. When Slope (b) is positive, line is upwards, when it is negative line is
downwards
2. When b is high, line is steep, when b is low, line is close to flat
3. b is proportionate movement between X and Y and a is the starting point.
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iv. Alternative formulas

𝐶𝑜𝑣(𝑥,𝑦)
1. 𝑏 =
𝜎𝑥 2
𝒏 ∑ 𝒙𝒚−∑ 𝒙 ∑ 𝒚
2. 𝒃 = 𝟐
𝒏 ∑ 𝒙 −(∑ 𝒙)𝟐
3. Solve for simultaneous equations
a. ∑𝒚 = 𝒏 𝒂 + 𝒃∑𝒙
b. ∑𝒙𝒚 = 𝒂∑𝒙 + 𝒃 ∑x2
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5.3 Markowitz portfolio theory

1. Basics
a. First portfolio theory to establish relationship between risk and return
b. It is also called as Markowitz Model of Risk-return Optimization
2. Portfolio risk and return of 2 security portfolio

a. Return(p) = W1R1 + W2R2 Where W1 and W2 are weights in security x and security y
and R1 and R2 are expected return of security x and security y
b. Risk(𝜎𝑝 ) = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟12 where 𝑟12 is the correlation
c. Variance𝜎𝑝2 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟12
3. Risk management
a. Zero risk portfolio( when r is r= -1)
𝝈𝟐 𝝈𝟏
𝒘𝟏 = 𝒘 =
𝝈𝟏 + 𝝈𝟐 𝟐 𝝈𝟏 + 𝝈𝟐
b. Minimum variance portfolio
𝜎22 − 𝜎1 𝝈2 𝑟𝟏2 𝝈1𝟐 − 𝝈𝟏 𝝈𝟐 𝒓𝟏𝟐
𝑤1 = 𝟐 𝒘2 =
𝝈1 + 𝝈𝟐𝟐 − 2𝝈𝟏 𝝈𝟐 𝒓𝟏𝟐 𝝈𝟐𝟏 + 𝝈𝟐𝟐 − 𝟐𝝈𝟏 𝝈𝟐 𝒓𝟏𝟐
4. Portfolio risk and return of 3 security portfolio

a. Return(p) = Return(p) = W1R1 + W2R2 + W3R3
Where W1 , W2 and W3 are weights in security x, security y and security z , and R1
, R2 and R3 are expected return of security x, security y and securities Z
b. Risk𝜎𝑝 = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 𝑤32 𝜎32 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟12 + 2𝑤2 𝑤3 𝜎2 𝜎3 𝑟23+ 2𝑤1 𝑤3 𝜎1 𝜎3 𝑟13
5. Impact of correlation
a. If r = +1
Risk(𝝈𝑝 ) = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 (1)
= √(𝑤1 𝜎1 )2 + (𝑤2 𝜎2 )2 + 2𝑤1 𝑤2 𝜎1 𝜎2
= √(𝑤1 𝜎1 + 𝑤2 𝜎2 )2
= 𝑤1 𝜎1 + 𝑤2 𝜎2
b. If r = -1
i. Risk(𝜎𝑝 ) = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 (−1)
= √(𝑤1 𝜎1 )2 + (𝑤2 𝜎2 )2 − 2𝑤1 𝑤2 𝜎1 𝜎2
= √(𝑤1 𝜎1 − 𝑤2 𝜎2 )2
= 𝑤1 𝜎1 − 𝑤2 𝜎2
c. Conclusions
i. Portfolio risk is highest when r is +1
ii. Portfolio risk is Least when r is -1
iii. Portfolio risk can be minimized by adding security with lower correlation
6. Efficient portfolio :
a. A portfolio is efficient if there exists no other portfolio that gives
7
i. More return for lower risk

ii. More return for same risk
iii. Same return for lower risk
b. Graphical representation
22.00
20.00
18.00
Return
16.00
14.00
12.00
10.00
0.00 5.00 10.00 15.00 20.00 Risk 25.00 30.00 35.00 40.00 45.00
7
5.4 Capital allocation line
1. Meaning: CAL reflects risk and return of various portfolios containing risk free asset and risky
securities
2. Why CAL
a. Main limitation of Markowitz theory is absence of explanation for risk free securities.
b. This is considered in capital allocation line where any point on this line will represent a
portfolio of risk free securities and risky securities.
3. Interpretation of line
a. When 100% investment is in risk free security then return would be risk free return and
risk would be 0 as in point “Rf” in chart.
b. When 100% investment is in risky security then return would be same as security return
and risk will be same as security risk as in point “s” in chart
c. Anything between Rf and S is a portfolio of investments.
d. When all securities follow same pattern, security is replaced by Market and CAL is
replaced by CML(capital market line)
4. Risk and return in CAL: Under CAL
a. Return of Portfolio = WsRs + WfRf
b. Risk of portfolio (𝝈p )= Ws*𝝈s + Wf*𝝈f = Ws*𝝈s
7
5.5 Capital Market line

1. Overall principle: CAL converges into CML when all investors investing in efficient portfolio
only
2. Basic assumption
a. The investor’s objective is to maximize the utility of terminal wealth;
b. Investors make choices on the basis of risk and return;
c. Investors have identical time horizon;
d. Investors have homogeneous expectations of risk and return;
e. Information is freely and simultaneously available to investors;
f. There is risk-free asset, and investor can borrow and lend unlimited amounts at the
riskfreerate;
g. There are no taxes, transaction costs, restrictions on short rates or other market
imperfections;
h. Total asset quantity is fixed, and all assets are marketable and divisible.
3. Graphical representation
Capital Market Line

9
8 𝑀𝑎𝑟𝑘𝑒𝑡
𝑅𝑚
7
6
Return
5
𝑅𝑓
4
3
2
1
𝜎𝑚
0
Risk
4. Theory
a. There is return for zero risk
b. Return for risk(risk premium) is proportion to risk of security(Desired) to market risk
c. As per CML every portfolio will have risk free return. To get additional return (risk
premium) risk profile should be applied. Risk premium is proportional to portfolio risk
and market risk.
i. Return(p) = WfRF + WmRm
𝝈p = Wm𝝈m
Wm =𝝈p/𝝈m
ii. Return(p) = Rf(1-Wm) + WmRm
Rf – RfWm + WmRm
Rf + wm (Rm –Rf)
Rp = Rf + 𝜎p (Rm –Rf)
𝜎m
7
5.6 Characteristic line

1. Meaning: It is the regression line with variables market return and securities return
2. Analysis
a. Establishes relationship between market return and securities return
b. It is a regressed line of best fit such a way that total of errors is zero.
c. If the correlation perfect, then actual and expected will be same.
d. Actual return may be above or below regression line
3. Graphical representation
4. Regression line
a. Rs = α + β Rm
𝑟𝜎𝑠
b. 𝛃 =
𝜎𝑚
c. 𝑎 = 𝑠̅ − 𝛃𝑚
̅
5. Types of risk
a. Systematic Risk:
i. Meaning: Due to dynamic nature of society the changes occur in the economic,
political and social systems constantly. These changes have an influence on the
performance of companies and thereby on their stock prices but in varying
degrees. Changes in returns of stock due macro factors are called systematic risk.
Hence risk of security can be estimated based on risk of market because of
common factors for movements of market and security.
ii. Examples: Interest rate, Inflation rate, GDP Data, Socio-political factors etc
2 2
iii. Formula of Systematic risk = 𝜎𝑚 𝛽𝑠 or 𝜎𝑠2 𝑟𝑠,𝑚
2
b. Unsystematic risk(𝝈𝟐𝒆 )
i. Meaning: Variability in returns of the security on account of micro factors is
known as unsystematic risk. These are movements in security returns which are
outside market factors.
ii. Unsystematic Risk examples: Financial risk, Labour issues, Product risk,
Management composition, Points to remember
iii. Formula of Unsystematic risk = 𝜎𝑠2 − 𝜎𝑚 2 2
𝛽𝑠 or 𝜎𝑠2 (1 − 𝑟𝑠,𝑚
2
)
iv.
7
c. Other points
i. When correlation is high systematic risk also will be high.
ii. Unsystematic risk can be minimized through diversification of securities.
iii. Systematic risk can’t be minimized since it market dependent which means when
market factors have negative impact, securities goes down and when market
factors recovers, securities also will have positive return
6. Portfolio risk using sharp index
a. It is calculated based on systematic risk and unsystematic risk of securities invested in
portfolio. It is different from Markowitz portfolio risk
b. Total risk of Portfolio(𝜎𝑝2 ) is sum of
2 2
i. Systematic risk of portfolio =𝜎𝑚 𝛽𝑝 where 𝛽𝑝 = 𝑊𝑥 𝛽𝑥 + 𝑊𝑦 𝛽𝑦 + ⋯
ii. Unsystematic risk of portfolio = 𝑤𝑥2 𝜎𝑒𝑥2
+𝑤𝑦2 𝜎𝑒𝑦
2
+…..
7
5.7 Beta
1. Meaning :
a. It is the measure of sensitivity between securities return and market return.
b. The standard deviation or variance provides a measure of the total risk associated with a
security.
c. The systematic risk of a security is measured by a statistical measure which is called Beta
2. Formule
Change in % return of security
a. Beta= or
Change in return % of market
rsm σs
b. β= Or
σm
Cov(s,m)
c. β = or
σ2m
𝑛 ∑ 𝑠𝑚−∑ 𝑠 ∑ 𝑚
d. β = 2
𝑛 ∑ 𝑚 −(∑ 𝑚)2
3. Interpretation of beta
a. β < 0: Asset generally moves in the opposite direction as compared to the index
b. β = 0: Movement of the asset is uncorrelated with the movement of the benchmark.
c. β of risk free securities will be 0
d. 0 < β < 1: Movement of the asset is generally in the same direction as, but less than the
movement of the benchmark
e. β = 1: Movement of the asset is generally in the same direction as, and about the same
amount as the movement of the benchmark
f. β of market portfolio will be 1
g. β > 1: Movement of the asset is generally in the same direction as, but more than the
movement of the benchmark
h. In general, high beta is high risk and low beta is low risk
4. Comparison of Beta, Correlation and SD
a. SD is representative of total risk of a security.
b. Beta is representative of systematic risk of security i.e proportion of movements between
market return and security return
c. Correlation is representative of direction of movements between market and security
return
5. Portfolio beta
a. Meaning: It is the sensitivity of portfolio return in comparison to market return
b. Formula:
i. Weighted average beta of individual securities
ii. βp = W1 β1 + W2β2
c. Other points
i. Premium required only for systematic risk.
ii. Correlation between securities for other reason not required to be considered
iii. If they are linked through the market , they are built in respective beta
iv. Portfolio beta is simple as compared portfolio s,d
6. Levered beta, unlevered(asset) and proxy beta
a. Unlevered beta
i. It is the project beta without being influenced by capital structure
ii. It reflects only business risk
iii. Also called as asset beta or project beta
7
b. Levered
i. It is the project beta adjusted for capital structure
ii. It reflects business risk and financial risk
iii. Also called as equity beta
c. Formulae
i. Levered Beta = Unlevered Beta + Unlevered Beta*Debt(1-t)
𝐷
ii. 𝛽𝐿 = 𝛽𝑢 [1 + 𝐸 (1-t)]
βL
iii. β𝑢 =
[1 +(1 - T) D / E]
d. Other points
i. In general, beta is levered beta
ii. Levered Beta should be higher than unlevered beta.
e. Proxy beta
i. It is the process of ascertaining risk level of future projects based on risk level of
existing firms in such sectors.
ii. The process of computation is as below
Step 1 : Compute Levered Beta of existing firms based on historical price
data
Step 2 : Compute Unlevered beta of existing firms using respective debt
equity ratio.
Step 3 : Compute average of undelivered beta to get representative of
business risk.(this step is applicable where multiple firms are considered)
iii. Step 4 : Compute Levered Beta of proposed project based on intended debt equity
ratio
7
5.8 Capital Asset Pricing Model or Securities Market Line

1. Theory
a. Relevant Assumptions of CAPM

i. The investor’s objective is to maximize the utility of terminal wealth.
ii. Investors make choices on the basis of risk and return.
iii. Investors have identical time horizon.
iv. Investors have homogeneous expectations of risk and return.
v. Information is freely and simultaneously available to investors.
vi. There is risk-free asset, and investor can borrow and lend unlimited amounts t the
risk-free rate.
vii. There are no taxes, transaction costs, restrictions on short rates or other market
imperfections.
viii. Total asset quantity is fixed, and all assets are marketable and divisible.
b. The Capital Asset Pricing Model was developed by Sharpe, Mossin and Linter in 1960.
The model explains the relationship between the expected return, non-diversifiable risk
and the valuation of securities. It considers the required rate of return of a security on the
basis of its contribution to the total risk.
c. It is based on the premises that the diversifiable risk of a security is eliminated when more
and more securities are added to the portfolio. However, the systematic risk cannot be
diversified and is or related with that of the market portfolio.
d. All securities do not have same level of systematic risk. The systematic risk can be
measured by beta, ß under CAPM, the expected return from a security can be expressed
as:
e. Expected return on security = Rf + Beta (Rm – Rf)
f. The model shows that the expected return of a security consists of the risk-free rate of
interest and the risk premium. The CAPM, when plotted on the graph paper is known as
the Security Market Line (SML). A major implication of CAPM is that not only every
security but all portfolios too must plot on SML.
g. This implies that in an efficient market, all securities are having expected returns
commensurate with their riskiness, measured by ß.
h. Thus, CAPM provides a conceptual framework for evaluating any investment decision,
where capital is committed with a goal of producing future returns
2. Formula
a. It measures the relationship between systematic risk and return expected for such risk
𝝈
b. 𝑹𝒔 = 𝑹𝒇 + 𝝈 𝒔 𝒓(𝑹𝒎 - 𝑹𝒇 )
𝒎
c. Rs = Rf + Beta (Rm-Rf)
d. Rm-Rf is called as risk premium of market
e. Beta (Rm-Rf) or Rs-Rf is risk premium of security
f. Capital Asset pricing model comprise of two elements
g. Return for time (risk free rate)
h. Return for risk (Risk premium)
3. A graphical representation of CAPM is the Security Market Line, (SML)
7
4. Comparison between CML and SML
5. Interpretation of CAPM for decusing making

a. CAPM return is the most popular measure for representation of investors required rate of
return i.e cost of equity
b. Expected return > CAPM return , stock is under-priced
c. Expected return < CAPM return , stock is overpriced
d. Difference is called as Jenson alpha
7
5.9 Arbitrage pricing theory
1. Theory
a. CAPM and sharpe single index model uses market portfolio as proxy for systematic
risk(Beta)
b. APT says that real source of systematic risk is not the change in market index, in fact it is
what made the market index, i.e macro economic factors
c. Examples business cycle risk, energy risk, foreign exchange risk
d. All the macro economic factors need not affect the company in same way
e. In APT, we regress the security return to each macro economic factors and find out beta
for each such sector. This is called as factor beta
2. Formula
a. Ke =𝜆0+𝜆1𝛽1+𝜆2𝛽2+……
b. where 𝜆1, 𝜆2 𝑎𝑟𝑒 𝑓𝑎𝑐𝑡𝑜𝑟 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚𝑠
7
5.10 Ratio parameters for selection of stocks

1. Treynor ratio (Reward to volatility ratio)
a. Portfolio return – risk free rate
Portfolio beta
b. Risk premium for every one unit of systematic risk
c. Higher the ratio better the returns
2. Shapre ratio (Reward to variability ratio)

a. Portfolio return – risk free rate
Portfolio SD
b. Risk premium for every one unit of total risk
3. Jensen’s Alpha
a. Jensen’s Alpha = Total Portfolio Return – Risk-Free Rate – [Portfolio Beta × (Market
Return – Risk-Free Rate)]
b. Actual return – CAPM Return
7
5.11 Summary chart
Coverage
Portfolio management
Sharpe single
Basics Markowitz risk CAPM APT
index
return optimization
theory
Capital Characteristic Factor
Returns
allocation line premium
Portfolio line
return
Risk Selection of Factor beta
Capital stock and
Portfolio risk market line proportion
Correlation
Securities
Minimum market line Sharpe ratio
variance
Regression portfolio Concept of
systematic Treynor ratio
risk
Efficient
frontier
Concept of
beta
Efficient
portfolio
selection
Portfolio Mangement
Meaning Examples Objective Basic Principal
Maximum To Make
Group of items Group of shares
Returns Decision
Allocation of
Minimum Risk Historical Data
time
Use average
7
Measurements
Return Risk
Average Types S.D Types
Securities Portfolio Market Security

return return Return risk
For Many ∑𝑥𝑤 = Portfolio

For a year With
Years risk
probability 𝑅1 𝑤1 +
𝑅2 𝑤2 +…
𝑃1 − 𝑃0 ∑𝑥 Market Risk
× 100 𝑥̅ =
𝑃0 𝑛 ෍ 𝑥𝑝
Stock market Index
Stock market
Index
Meaning Objective Measured by Computation
Number which To reflect

Index Points Index today =
represents movements of
movements
group of Notional
companies/ Investment Mcap Today*Index previous day
Notional market Mcap Previous Day
portfolio of
shares
7
Basic concepts on risk
Risk
Unit of
Measuremen Interpretatio
measuremen Calculation
t n
t
Same unit of Expectation

∑ 𝑥−𝑥 2
SD =𝜎 Variance=𝜎 2 variable x SD can be of stock
like %, Rs, 𝑛
return
Km
Average
Average area In this Average + ෍ 𝑝(𝑥 − 𝑥)2
length of Positive or
of deviation chapter only SD
deviation
%
Used for
Used for
simplificatio Negative Rsx + 𝜎
expressions
ns
Correlation
Interpretatio Range of Type of

Meaning Measurement
n Values correlation
Chances of
Correlation
Measure of variables -1 to +1 Positive
co-efficient
moving
Strength and in same 𝐶𝑜𝑣

direction or r= 𝜎 Negative
nature of 𝑥 𝜎𝑦
variables different
direction
𝐶𝑜𝑣 𝑥, 𝑦 No
correlation
= ෍ 𝑝𝑥 𝑥 − 𝑥 𝑦 − 𝑦
7
Regression line
Regression
Equation of line,
Why Meaning
Y = a + bX
Mathematical X is
Correlation relationship independent b is slope a is intercept
cant be used between two variable
for estimation variables
Y is
Represented by Proportion of Starting point
dependent
line movement of line
variable
(best fit)
𝑟𝜎𝑦
𝑏= 𝑎 = 𝑦ത − 𝑏𝑥̅
𝜎𝑥
Markowitz Sharpe Index CAPM APT
Security Average of previous years Average of Rs = Ke

return or previous years Rf + Beta(Rm- =𝜆0+𝜆1𝛽1+
Expected returns in or Rf) 𝜆2𝛽2+……
future*Respective Expected
probability returns in
future*Respecti
ve probability
Security Standard deviation 𝑽𝒙 Beta of security W1* 𝛽1
risk = 𝜷𝒔 𝟐 𝝈𝒎 𝟐 +w2* 𝛽2
+ 𝝈𝟐𝒆𝒔
Portfolio W1R1 + W2R2 W1R1 + W2R2 Rp = Ke
return Rf + Beta(Rm- =𝜆0+𝜆1𝛽1+
Rf) 𝜆2𝛽2+……
7
Portfolio Total risk Beta of W1* 𝛽1

risk √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2=𝑟12
Systematic + portfolio +w2* 𝛽2
Unsystematic
√𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝐶𝑜𝑣 = βp = W1 β1 +
If r = +1, 𝒘𝟏 𝝈𝟏 + 𝒘𝟐 𝝈𝟐 𝝈𝟐𝑚 𝜷𝟐𝒑 +𝒘𝟐𝒙 𝝈𝟐𝒆𝒙 W2β2
If r = -1, 𝒘𝟏 𝝈𝟏 − 𝒘𝟐 𝝈𝟐 +𝒘𝟐𝒚 𝝈𝟐𝒆𝒚
Zero risk portfolio

( when r is r= -1)
𝝈𝟐
𝒘𝟏 = 𝒘
𝝈𝟏 + 𝝈𝟐 𝟐
𝝈𝟏
=
𝝈𝟏 + 𝝈𝟐
Minimum variance
portfolio
𝑤1
𝜎22 − 𝜎1 𝝈2 𝑟𝟏2
= 𝟐
𝝈1 + 𝝈𝟐𝟐 − 2𝝈𝟏 𝝈𝟐 𝒓𝟏𝟐
7
Markowitz portfolio theory/ Markowitz Model of Risk-return Optimization
A portfolio is efficient if there exists no other portfolio that gives

• More return for lower risk
• More return for same risk
• Same return for lower risk
•
•
22.00
20.00
18.00
Return
16.00
14.00
12.00
10.00
0.00 5.00 10.00 15.00 20.00 Risk 25.00 30.00 35.00 40.00 45.00
Computation format for risk of two securities and portfolio risk

x y p x*p y*p x-x (x-x)2 p(x- p(y-y)2 y-y (x-x)(y-
y)p
2
x)
Total 1 x y Varian Varian Covariance
7
Characteristic line
a. Establishes relationship between market return and securities return
b. It is a regressed line of best fit such a way that total of errors is zero.
c. If the correlation perfect, then actual and expected will be same.
d. Actual return may be above or below regression line
Regression line
• Rs = α + β Rm
𝑟𝜎
• 𝛃= 𝑠
𝜎𝑚
• 𝑎 = 𝑠̅ − 𝛃𝑚
̅
Risk
Systematic Risk Unsystematic Risk
Market risk Business Risk
Interest Rate Risk: Financial Risk:
Social or Regulatory Risk Default Risk
Purchasing Power Risk
Computation format for beta and characteristic line

m s m-m (m-m)2 s--s (s-s)2 (s-s)(m-m)
Total 1 Variance of Market Variance of Covarince

securit
7
Beta
Comparison of Beta, Correlation and SD
Measures
S.d-𝝈 Correlation-r Beta-𝜷
Probability of Proportionate
Total Risk movements
direction of
movements between security
and market
between security
and market Systematic risk
7
CAPM
7
Levered beta, unlevered(asset) and proxy beta
Proxy beta
Ratio parameters for selection of stocks
Ratio Formula
Treynor ratio Portfolio return – risk free rate
Portfolio beta
Shapre ratio Portfolio return – risk free rate

Portfolio SD
Jensen’s Alpha Portfolio return – CAPM Return
7
5.12 Problems
Problem No 1. Index calculation
Following is the data on investments on two different dates
Stock No of shares Price on 31st 1st January

December 2013 2014
A 5,000 70 77
B 4,000 20 21
C 2,000 65 78
D 10,000 20 26
E 2,500 96 120
(i) Compute investments on both dates and average return

(ii) If above investments were considered as stock Index and as on 31st December if index is 10,000.
Compute index as on 1st January 2014
Problem No 2. SD with returns
A stock costing Rs 120 pays no dividends. The possible prices that the stock might sell for at the end
of the year with the respective probabilities are:
Price Probability
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
Required: Calculate the expected return and Calculate the Standard deviation of returns.
(Answer Hint : 5.91% )
Problem No 3. Correlation and regression
Compute correlation co-efficient, build regression equation and also analyse co-efficient of
determination
Year Market Returns Security A returns
1 10 4
2 12 14
3 13 14
4 15 18
5 -5 -15
(Answer Hint : r = 0.98, slope = 1.628)
7
Problem No 4. Portfolio risk and return
Oliver’s portfolio holds security A, which returned 12.0% and security B, which returned 15.0%. At
the beginning of the year 70% was invested in security A and the remaining 30% was invested in
security B. Given a standard deviation of 10% for security A, 20% for security B and a correlation
coefficient of 0.5 between the two securities.
Calculate the portfolio returns and portfolio variance.
(Answer Hint :12.9, 11.27 )
Problem No 5. Impact of negative correlation
Assume r = -0.5 in the previous problem and recalculate the portfolio risk
Problem No 6. Impact of changes in weights on portfolio risk
Securities Security A Security B

Return 12 20
S.D 20 40
Correlation -0.2
Discuss Portfolio risk and return at following proportions of A and B
A B
100% 0%
90% 10%
75.9% 24.1%
50% 50%
25% 75%
0% 100%
Problem No 7. Efficient portfolio selection

MTP May 2017,RTP November 2017,MTP May 2013, MTP November 2017, MTP June 2021
Following is the data regarding six securities:
Securities A B C D E F
Return (%) 8 8 12 4 9 8
Risk (S.D) 4 5 12 4 5 6
(i) Assuming three will have to be selected, state which ones will be picked.
(ii) Assuming perfect correlation, show whether it is preferable to invest 75% in A & 25% in C or to
invest 100% in E
(Answer Hint : Hence, the ones to be selected are A, C & E., For the same 9% return the risk is lower
in E. Hence, E will be preferable )
Problem No 8. Portfolio risk with probability

RTP November 2012,MTP November 2015 MTP November 2016,RTP May 2019
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An investor has decided to invest Rs 1,00,000 in the shares of two companies, namely, ABC and
XYZ. The projections of returns from the shares of the two companies along with their probabilities
are as follows:
Probability ABC(%) XYZ(%)

0.20 12 16
0.25 14 10
0.25 -7 28
0.30 28 -2
You are required to

(i) Comment on return and risk of investment in individual shares.
(ii) Compare the risk and return of these two shares with a Portfolio of these shares in equal
proportions.
(iii) Find out the proportion of each of the above shares to formulate a minimum risk portfolio.
(Answer Hint : (i) Security X Return = 12.55,SD = 12.95, Security y , retutn = 12.10, risk =11.27 (ii)
portfolio risk 1.25, return = 12.32, (iii) 46%, 54%)
Problem No 9. CML application
Efficient market security provides return of 12.5%with risk of 21%. If acceptable risk is 25%, find
how much return can be expected. Risk free rate 12%
(Answer Hint : 12.595 )
Problem No 10. Markowitz with n securities and CAL RTP November 2010
Suppose that in the universe of available risky securities contains a large number of shares two stocks,
identically distributed with E(r) = 15%, or σ = 60%, and with a common correlation coefficient of ρ=
0.5.
(a) What is the expected return and standard deviation of an equally weighted risky portfolio of 25
stocks?
(b) What is the smallest number of stocks necessary to generate an efficient portfolio with a standard
deviation equal to or smaller than 43%?
(c) What is the systematic risk in this security universe?
(d) If T-bills are available and yield 10%, what is the slope of the CAL?
(Answer Hint : (i) 43.27 (ii) 36.73 (iii) 42.42 (iv) 11.78% )
Problem No 11. Building characteristic line and analyzing risk June 2009 (8 Marks)
The returns on stock A and market portfolio for a period of 6 years are as follows:
Year Return on A (%) Return on market portfolio (%)

1 12 8
2 15 12
3 11 11
4 2 -4
5 10 9.5
6 -12 -2
You are required to determine:
(i) Characteristic line for stock A
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(ii) The systematic and unsystematic risk of stock A.
(Answer Hint : y=-0.58 + 1.202x , 0.70 0.30)
Problem No 12. Sharpe Index

May 2012(8 Marks),RTP November 2016, MTP November 2018
A has portfolio having following features:
Security β Random Error σei Weight

L 1.60 7 0.25
M 1.15 11 0.30
N 1.40 3 0.25
K 1.00 9 0.20
You are required to find out the risk of the portfolio if the standard deviation of the market index (σm)
is 18%
Problem No 13. Sharpe Index May 2019(N)(8 Marks)
Following are the details of a portfolio consisting of 3 shares:

Standard Deviation of Market Portfolio Return = 12%
Shares Portfolio Weight Beta Expected Return (%) Total Variance

X Ltd. 0.3 0.50 15 0.020
Y Ltd. 0.5 0.60 16 0.010
Z Ltd. 0.2 1.20 20 0.120
You are required to calculate the following:

(i) The Portfolio Beta.
(ii) Residual Variance of each of the three shares.
(iii) Portfolio Variance using Sharpe Index Model.
(Answer Hint : i) Portfolio Beta = 0.69, (ii) Residual Variance 0.0164 , 0.0048 0.0993 (iii) Portfolio
variance using Sharpe Index Model 0.013504 )
Problem No 14. Beta using probability November 2018(O)(8 Marks)
Mr. Gupta is considering investment in the shares of R. Ltd. He has the following expectations of
return on the stock and the market:
Return (%)
Probability R. Ltd. Market
0.35 30 25
0.30 25 20
0.15 40 30
0.20 20 10
(i) Calculate the expected return, variance and standard deviation for R. Ltd.
(ii) Calculate the expected return variance and standard deviation for the market.
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(iii) Find out the beta co-efficient for R. Ltd. shares.

(Answer Hint : (i) Expected Return 28.%, σ = 6.20% (ii) Expected Return= 21.25%,σ =6.5%,(iii)
Beta= 0.89 )
Problem No 15. Beta and CAPM ( 6 marks) (May 1998)
An investor is seeking the price to pay for a security, whose standard deviation is 3.00 per cent. The
correlation coefficient for the security with the market is 0.8 and the market standard deviation is 2.2
per cent. The return from government securities is 5.2 per cent and from the market portfolio is 9.8
per cent. The investor knows that, by calculating the required return, he can then determine the price
to pay for the security. What is the required return on the security?
(Answer Hint : 10.22% )
Problem No 16. CAPM Reverse calculation

RTP May 2013, MTP May 2016,RTP May 2018, ,MTP May 2019
The following information is available in respect of Security X

Equilibrium Return 15%
Market Return 15%
7% Treasury Bond Trading at $140
Covariance of Market Return and Security Return 225%
Coefficient of Correlation 0.75
You are required to determine the Standard Deviation of Market Return and Security Return
(Answer Hint : (i) Standard Deviation of Market Return = 15%, (ii) Standard Deviation of Security
Return = 11.25%)
Problem No 17. CAPM for valuation Nov 2010 (5 Marks), MTP November 2016
Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid dividend
@ Rs 3 per share. The rate of return on market portfolio is 15% and the risk-free rate of return in the
market has been observed as10% . The beta co-efficient of the company’s share is 1.2.
You are required to calculate the expected rate of return on the company’s shares as per CAPM model
and the equilibirium price per share by dividend growth model.
(Answer Hint : equilibrium price per share will be Rs. 84)
Problem No 18. Risk management in CAPM May 2019(O)(8 Marks), MTP May 2020, MTP
June 2021
Ms. Preeti, a school teacher, after retirement has built up a portfolio of Rs 1,20,000 which is as
follow:
Stock No. of shares Market price per share (Rs) Beta

ABC Ltd. 1000 50 0.9
DEF Ltd. 500 20 1.0
GHI Ltd. 800 25 1.5
JKL Ltd. 200 200 1.2
Her portfolio consultant Sri Vijay has advised her to bring down the, beta to 0.8. You are required to
compute:

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(i) Present portfolio beta

(ii) How much risk free investment should be bought in, to reduce the beta to 0.8?. Show workings to
prove that beta of 0.8 is achieved
(Answer Hint : Portfolio beta 1.108, Additional investment in zero risk should be (Rs 1,66,205 – Rs
1,20,000) = Rs 46,205)
Problem No 19. Market return and CAPM MTP May 2015
A holds the following portfolio:

Share/Bond Beta Initial Price Rs. Dividends Rs. Market Price at
end of year Rs.
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0.01 1,000 140 1,005
Calculate:
(i) The expected rate of return on his portfolio using Capital Asset Pricing Method (CAPM)
(ii) The average return of his portfolio.
Risk-free return is 14%.
(Answer Hint : (i) Expected Rate of Return for each security is 23.86%, 22.63%, 20.47%, 14.12% (ii)
Average return = 20.2% )
Problem No 20. CAPM in two years MTP November 2015, MTP May 2018,
An investor is holding 1,000 shares of Fatlass Company. Presently the rate of dividend being paid by
the company is Rs. 2 per share and the share is being sold at Rs. 25 per share in the market. However,
several factors are likely to change during the course of the year as indicated below
Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%
In view of the above factors whether the investor should buy, hold or sell the shares? And why?
(Answer Hint : Price of share (Revised) 36.33 )
Problem No 21. Proxy beta and WACC
The XYZ Ltd. in the manufacturing business is planning to set up an software development company.
The project will have a D/E ratio of 0.27.The company has identified following four pureplay firms in
the line of software business.
Pureplay firm βL D/E

ABC 1.1 0.3
DEF 0.9 0.25
GHI 0.95 0.35
JKL 1.0 0.3

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Assume tax rate applicable to XYZ Ltd. as 35 per cent
Given that Rf is 12%, Kd before tax is 14% and RM is 18%, you are required to compute the WACC
to be used to compute NPV of the project
Problem No 22. Beta and APT June 2009 (8 Marks)
Mr. X owns a portfolio with the following characteristics:
Particulars Security A Security B Risk Free security

Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%
It is assumed that security returns are generated by a two-factor model.

(i) If Mr. X has Rs 1,00,000 to invest and sells short Rs 50,000 of security B and purchases Rs
1,50,000 of security A what is the sensitivity of Mr. X’s portfolio to the two factors?
(ii) If Mr. X borrows Rs 1,00,000 at the risk-free rate and invests the amount he borrows along with
the original amount of Rs 1,00,000 in security A and B in the same proportion as described in part
(i), what is the sensitivity of the portfolio to the two factors?
(iii) What is the portfolio expected return premium in (ii) above?
(iv) What is the expected return premium of factor 2?
(Answer Hint : (i) 0.45, 0.30 (ii) 0.90,0.60 (iii) 5%)
Problem No 23. Master problem in portfolioNovember 2016(8 Marks), MTP May 2019,RTP
November 2020
Mr. Abhishek is interested in investing Rs 2,00,000 for which he is considering following three
alternatives:
(i) Invest Rs 2,00,000 in Mutual Fund X (MFX)
(ii) Invest Rs 2,00,000 in Mutual Fund Y (MFY)
(iii) Invest Rs 1,20,000 in Mutual Fund X (MFX) and Rs 80,000 in Mutual Fund Y (MFY)
Average annual return earned by MFX and MFY is 15% and 14% respectively. Risk free rate of
return is 10% and market rate of return is 12%.
Covariance of returns of MFX, MFY and market portfolio Mix are as follow:
MFX MFY Mix

MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
M 3.370 2.800 3.100

(i) Variance of return from MFX, MFY and market return,
(ii) Portfolio return, beta, portfolio variance and portfolio standard deviation,
(iii) Expected return, systematic risk and unsystematic risk; and
(iv) Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix

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Problem No 24. Portfolio rebalancing MTP May 2018
Ms. Kiran had a surplus fund of Rs 2,00,000 on 31.03.2016. She is interested in constructing a
portfolio of shares of the core sectors to be weighted equally in rupee value terms. Her friend Shaila
based on her research advised her to purchase following shares:
Company No. of Shares Price Per Share

O Ltd. 100 400
H Ltd. 1000 40
A Ltd. 320 125
R Ltd. 400 100
T Ltd. 200 200
On April 1, 2016, the prices of these stocks were as follows:
Company Price Per Share

O Ltd. 300
H Ltd. 60
A Ltd. 120
R Ltd. 150
T Ltd. 125
You are required to exhibit how Kiran can rebalance her portfolio on 1.4.2016 so that her exposure to
individual stock is maintained at original level in terms of rupee value
(Answer Hint : Revised Value of Portfolio 2,13,400 )
Problem No 25. Impact of debt on overall risk RTP May 2021
Equity of ABC Ltd. (ABCL) is Rs 500 Crores, its debt, is worth Rs 290 Crores. Printer Division
segments value is attributable to 64%, which has an Asset Beta (βp) of 1.55, balance value is applied
on Spares and Consumables Division, which has an Asset Beta (βsc) of 1.40 ABCL Debt beta (βD) is
0.28.
(i) Equity Beta (βE),
(ii) Ascertain Equity Beta (βE), if ABC Ltd. decides to change its Debt Equity position by raising
further debt and buying back of equity to have its Debt to Equity Ratio at 1.50
Assume that the present Debt Beta (βD1) is 0.45 and any further funds raised by way of Debt will
have a Beta (βD2) of 0.50.
(iii) Whether the new Equity Beta (βE) justifies increase in the value of equity on account of
leverage?
Problem No 26. Evaluation using CAPM RTP May 2021
K Ltd. has invested in a portfolio of short-term equity investments. You are required to calculate the
risk of K Ltd.’s short-term investment portfolio relative to that of the market from the information
given below:
Investment A B C D
No. of shares 1,20,000 1,60,000 2,00,000 2,50,000
Market price per share (Rs) 8.58 5.84 4.34 6.28

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Beta 2.32 4.56 1.80 3.00

Expected Dividend Yield 9.50% 14.00% 7.50% 16.00%
The current market return is 20% and the risk free return is 10%.
Advise whether K Ltd. should change the composition of its portfolio. If yes, then how.
Note: Make calculations upto 4 decimal points.

7
MUTUAL FUNDS
Marks distribution

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6.1 Basics of Mutual funds

1. Meaning :
a. A ‘mutual fund’ means a fund established in the form of a trust to raise monies through
the sale of units to the public under one or more schemes for investing in securities
including money market instruments
b. A mutual fund invests the money received from investors in instruments which are in line
with the objectives of the respective schemes.
2. Regulated by SEBI (Mutual Funds) Regulations, 1996

3. Process flow
4. Advantages and disadvantages of funds

a. Advantages
i. Professional Management
ii. Diversification
iii. Convenient Administration
iv. Low Cost of Management:
v. Liquidity
vi. Highly Regulated
b. Disadvantages of Mutual Fund
i. No guarantee of Return
ii. Selection of Proper Fund
iii. Cost Factor
iv. Transfer Difficulties
5. Classification of mutual funds

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Mutual funds
Objective Sponsorship
Function based Portfolio based
based based
Open ended Public Sector

Equity funds Debt Funds Balanced funds Index Funds
funds Mutual Funds
Close ended International Private Sector

Growth Funds Bond Funds
funds Funds Mutual Funds
Aggressive Foreign
Interval Funds Gilt Funds Sector Funds
Funds Mutual Funds
Money Market
Income Funds
Funds
Tax Savings
schemes
6. Exchange Traded Funds

a. An ETF combines the valuation feature of a mutual fund or unit investment trust, which
can be bought or sold at the end of each trading day for its net asset value, with the
tradability feature of a closed-end fund
b. Index ETFs - Most ETFs are index funds that hold securities and attempt to replicate the
performance of a stock market index
c. Commodity ETFs - Commodity ETFs invest in commodities, such as precious metals and
futures
7. Evaluation of mutual funds
a. NAV per unit
Net Assets Value (NAV) = Total market value of holdings+ Cash+ - liabilities
Unit size
b. Valuation norms
Particulars Valuation
Cash As per books.
All listed and traded securities Closing Market Price
Listed Debentures and Bonds Closing traded price
Fixed Income Securities Current Yield
c. Expense Ratio = Expense / Average value of Portfolio

d. Investors returns = Dividends + Realized gains + P1 – P0
P0
e. Load in mutual funds
i. Front end load:
1. It is the amount the that is deducted from investment made by
unitholders. Only net amount is invested by mutual fund in market
instruments. It is similar to purchase commission.
2. Public offer price = Net Asset Value

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1 – Front end Load %

ii. Back end load
1. It is the amount that is deducted from sales proceeds of investment at the
time of redemption to unitholders. It is similar to sales commission
2. Redemption price = Net Asset Value
1 + Back end Load %

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6.2 Summary chart
Classification of mutual funds
Mutual funds
Function Portfolio Objective Sponsorship

based based based based
Open ended Balanced Public Sector

Equity funds Debt Funds Index Funds
funds funds Mutual Funds
Private
Close ended Growth International
Bond Funds Sector
funds Funds Funds
Mutual Funds
Interval Aggressive Foreign

Gilt Funds Sector Funds
Funds Funds Mutual Funds
Income Money
Funds Market Funds
Tax Savings
schemes
Evaluation of mutual funds

Current Net Assets Value (NAV)
= Total market value of holdings+ Cash+other assets - All MF liabilities
Unit size
Valuation norms
• Cash : As per books.
• All listed and traded securities: Closing Market Price
• Listed Debentures and Bonds Closing :traded price
• Fixed Income Securities :Current Yield
Front end load and back end load

• Front end load
o It is the amount the that is deducted from investment made by unitholders.
o Public offer price = Net Asset Value
1 – Front end Load %
o It is similar to purchase commission.
• Back end load
o It is the amount that is deducted from sales proceeds of investment at the time of
redemption to unitholders.
o Redemption price = Net Asset Value
1 + Back end Load %
o It is similar to sales commission.

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6.3 Problems
Problem No 1. NAV calculation May 2016(6 Marks)
Calculate the NAV of a regular income scheme on per unit basis of Red Bull mutual fund from the
following information:
Particulars Rs in crores
Listed shares at cost (ex-dividend) 30
Cash in hand 0.75
Bonds & Debentures at cost (ex-interest) 2.30
Of these, bonds not listed & not quoted 1.0
Other fixed interest securities at cost 2.50
Dividend accrued 0.8
Amount payable on shares 8.32
Expenditure accrued 1.00
Value of listed bonds & debentures at NAV date 10
1. Number of units (Rs10 face value) 30 lakhs

2. Current realizable value of fixed income securities of face value of Rs 100 is 106.50
3. The listed shares were purchased when index was 7100 and the Present index is 9000
4. Unlisted bonds and debentures are at cost. Other fixed interest securities are also at cost.
Problem No 2. Returns for investors from NAV

MTP May 2014, MTP November 2016, MTP May 2020
A mutual fund that had a net asset value of Rs16 at the beginning of a month, made income and
capital gain distribution of Rs0.04 and Rs0.03 respectively per unit during the month, and then ended
the month with a net asset value of Rs16.08.
Calculate monthly and annual rate of return
(Answer Hint : r = 0.9375% or 11.25% p.a.)
Problem No 3. Returns for investors from NAV
A mutual fund, that had a net asset value of Rs 10 at the beginning of the month, made income and
capital gain distribution of Rs 0.05 and Rs 0.04 per unit respectively during the month and then ended
the month with a net asset value of Rs 10.03.
Compute the monthly return.
(Answer Hint : Monthly Return = (0.05 + 0.04 + 0.03) / 10 × 100 = 1.2%.)
Problem No 4. Returns for investors from NAV- Close ended fund MTP November 2015
The NAV of per unit of XYZ Mutual Fund (a Close Ended Funds) on 1.1.2014 was Rs. 28. The value
on 31.12.2014 comes to Rs. 28.80. On the same date unit was trading in market at a premium of 3%

7
though on 1.1.2014 same was trading at a discount at 5%. On 31.12.2014, XYZ distributed a sum of
Rs. 2.80 as incomes and capital gains.
You are required to compute rate of return to the investor during the year.
(Answer Hint : XYZ Mutual Fund (a Close Ended Funds 22%)
Problem No 5. Investors required rate of return June 2009(6 Marks)
Mr. X earns 10% on his investments in equity shares. He is considering a recently floated scheme of a
Mutual Fund where the initial expenses are 6% and annual recurring expenses are expected to be 2%.
How much the Mutual Fund scheme should earn to provide a return of 10% to Mr. X?
Problem No 6. NAV yield November 2016(5 Marks)
Mr. A has invested in three Mutual Fund (MF) schemes as per the details given below:
Particulars MF ‘A’ MF ‘B’ MF ‘C’

Date of Investment 01-11-2015 01-02-2016 01-03-2016
Amount of investment (Rs) 1,00,000 2,00,000 2,00,000
Net Asset Value (NAV) at entry date (Rs) 10.30 10.00 10.10
Dividend Received upto 31-3-2016 (Rs) 2,850 4,500 NIL
NAV as on 31-3-2016 (Rs) 10.25 10.15 10.00
Assume 1 year = 365 days.
Show the amount of rupees upto two decimal points.
You are required to find out the effective yield (upto three decimal points) on per annum basis in
respect of each of the above three Mutual Fund (MF) schemes upto 31-3-2016
(Answer Hint : Effective yield p.a 5.678% , 22.813%, (-) 11.657%)
Problem No 7. Yield with multiple plans Practice Manual(Old)
A mutual fund company introduces two schemes i.e. Dividend plan (Plan-D) and Bonus plan (Plan-
B). The face value of the unit is Rs 10. On 1-4-2005 Mr. K invested Rs 2,00,000 each in Plan-D and
Plan-B when the NAV was Rs 38.20 and Rs 35.60 respectively. Both the plans matured on 31-3-2010.
Particulars of dividend and bonus declared over the period are as follows:
Net Asset Value (Rs)
Date Dividend % Bonus Ratio Plan D Plan B
30-09-2005 10 39.1 35.6
30-06-2006 1:5 41.15 36.25
31-03-2007 15 44.2 33.1
15-09-2008 13 45.05 37.25
30-10-2008 1:8 42.7 38.3
27-03-2009 16 44.8 39.1
11-04-2009 1:10 40.25 38.9
31-03-2010 40.4 39.7

7
What is the effective yield per annum in respect of the above two plans?
(Answer Hint : 3.9%, 13.12%)
Problem No 8. NAV reverse calculation MTP May 2017
Mr. X on 1.7.2007, during the initial offer of some Mutual Fund invested in 10,000 units having face
value of Rs. 10 for each unit. On 31.3.2008, the dividend operated by the M.F. was 10% and Mr. X
found that his annualized yield was 153.33%. On 31.12.2009, 20% dividend was given. On 31.3.2010,
Mr. X redeemed all his balance of 11,296.11 units when his annualized yield was 73.52%.
What are the NAVs as on 31.3.2008, 31.3.2009 and 31.3.2010?
(Answer Hint : Rs20.50, Rs 25.95 , Rs 26.75 )
Problem No 9. NAV reverse calculation November 2018(O)(5 Marks)
During the year 2017 an investor invested in a mutual fund. The capital gain and dividend for the year
was Rs 3.00 per unit, which were re-invested at the year end NAV of Rs 23.75. The investor had total
units of 26,750 as at the end of the year. The NAV had appreciated by 18.75% during the year and
there was an entry load of Rs 0.05 at the time when the investment was made.
The investor lost his records and wants to find out the amount of investment made and the entry load
in the mutual fund.
(Answer Hint : Investment Amount = 23,750 units (Rs 20 + Rs 0.05) = Rs 4,76,187.50 Entry load =
Rs 1,187.50 i.e. (23750 × Rs 0.05))
Problem No 10. Multiple plans Issue price calculation November 2020(10 Marks)
M/S. Corpus an AMC, on 1.04.2015 has floated two schemes viz. Dividend Plan and Bonus Plan. Mr.
X, an investor has invested in both the schemes. The following details (except the issue price) are
available:
Additional details
Investment (Rs) Rs 9,20,000 Rs 10,00,000
Average Profit (Rs) Rs 27, 748.60
Average Yield (%) 6.40
You are required to calculate the issue price of both the schemes as on 1.04.2015

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Problem No 11. Evaluation using ratios November 2020(8 marks)
The following are the details of three mutual funds of MFL:

Growth Fund Balanced Fund Regular Fund Market
Average Return (%) 7 6 5 9
Variance 92.16 54.76 40.96 57.76
Coefficient of Determination 0.3025 0.6561 0.9604
The yield on 182 days Treasury Bill is 9 per cent per annum.
(i) Rank the funds as per Sharpe's measure.
(ii) Rank the funds as per Treynor's measure.
(iii) Compare the performance with the market.
Problem No 12. Dividend equalisation January 2021(8 Marks)
On 1st January, 2020, an open ended scheme of mutual fund had outstanding units of 300 lakhs with a
NAV of Rs 20.25. At the end of January 2020, it had issued 5 lakhs units at an opening NAV plus a
load of 2%, adjusted for dividend equalisation. At the end of February 2020, it had repurchased 2.5
lakhs units at an opening NAV less 2% exit load adjusted for dividend equalisation. At the end of
March 2020, it had distributed 70 per cent of its available income. In respect of January - March
quarter, the following additional information is available:
Value appreciation of the portfolio Rs 460 lakhs

Income for January Rs 24 lakhs
Income for February Rs 36 lakhs
Income for March Rs 47 lakhs
You are required to calculate: (i) Income available for distribution (ii) Issue price at the end of
January (iii) Repurchase price at the end of February (iv) Closing Value of Net Assets at the end of
March.
Problem No 13. NAV with sector Index RTP May 2021
The following particulars relating to S Fund Schemes

Particulars Value Rs in Crores
1. Investment in Shares (at cost)
a. Pharmaceuticals companies 158
b. Construction Industries 62
c. Service Sector Companies 112
d. IT Companies 68
e. Real Estate Companies 20
2. Investment in Bonds (Fixed Income)
a. Listed Bonds (8000, 14% Bonds of Rs 15,000 each) 24
b. Unlisted Bonds 14
3. No. of Units outstanding (crores) 8.4
4. Expenses Payable 7
5. Cash and Cash equivalents 3
6. Market expectations on listed bonds 8.842%
The fund has incurred the following expenses:

Consultancy and Management fees Rs 520 Lakhs

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Office Expenses Rs 180 Lakhs

Advertisement Expenses Rs 48 Lakhs
Particulars relating to each sector are as follows:
Sector Index on Purchase date Index on Valuation date
Pharmaceutical companies 300 500
Construction Industries 275 490
Service Sector Companies 285 500
IT Companies 270 515
Real Estate Companies 265 440
Required:
(i) Calculate the Net Asset Value of the fund
(ii) Calculate the Net Asset Value per unit
(iii) Determine the Net return (Annualized), if the period of consideration is 4 years, and the fund has
distributed Rs 2 per unit per year as cash dividend during the same period.
Note: Calculate figure in Rs Crore upto 3 decimal points

7
DERIVATIVES
Marks distribution

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7.1 Basics of Derivatives

1. Meaning:
a. A derivative is a contract between two or more parties whose value is based on an agreed-
upon underlying financial asset, index or security.
b. Common underlying instruments include: bonds, commodities, currencies, interest rates,
market indexes and stocks.
c. Derivative Is a contract not physical an asset but derives value from underlying asset
2. Essential features of derivatives
a. Settled at a future date
b. Value will change in response to underlying asset
c. Requires no investment or minimal investment as compared to underlying asset
3. Types
a. Options
b. Futures contracts,
c. forward contracts,
d. Swaps
4. Purpose
a. Speculation: Seek to profit from changing prices in the underlying asset, index or security
b. Hedging: Used as tool to cover risk against change in prices of underlying asset
c. Arbitrage: Making riskless profit through taking advantage in imperfect market prices
5. Basic Assumption
a. Zero position
b. Opportunity cost
6. Settlement types
a. Delivery basis
b. Net basis
7. Positions in investment
a. Long position
b. Short position
8. Strategies- Sequence
a. Under Long position
i. Now: Borrow Money and Purchase shares
ii. Later: Sell shares and Repay Money
iii. Differential cash on hand is profit
b. Under Short Position
i. Now : Borrow shares and Sell shares
ii. Later : Purchase shares and Repay shares
iii. Differential cash on hand is profit

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7.2 Futures
1. Meaning
a. A financial contract obligating the buyer to purchase an asset (or the seller to sell an
asset), such as a physical commodity or a financial instrument, at a predetermined future
date and price
b. Underly assets can be shares, Indices, commodity prices etc
2. Features
a. Basic features which is similar to forward contract
i. Contract signed today, settled at later date
ii. Price for transaction is pre-determined
iii. Settlement date is pre-determined
iv. Both parties to contract have obligation, one will have obligation to buy and
another obligation to sell
b. Additional features because traded in stock exchange
i. Standard Expiry date
ii. Standard Lot size
iii. Initial margin money or deposit (determined by SPAN)
iv. Square off settlement
v. Market to Market Settlement
vi. Early settlement
3. Comparison with options
a. Unlike options both parties are obliged to execute contract
b. No premium involved
4. Advantages of Futures Trading Vs. Stock Trading
a. Leverage: An investor can invest more money than he has since only margin money is
required to be maintained.
b. Ease of Shorting : Because of square off settlement, short position is convenient without
physical delivery.
c. Flexibility: Future investors can use the instruments to speculate, hedge, spread or for use
in a large array of sophisticated strategies.
5. Margin
a. One has to maintain account with stock exchange to deal in futures.
b. Difference in future prices is debited/credited to this account on daily basis.
c. Types of margin
i. Initial margin : When contract is entered into
ii. Maintenance margin : Minimum Amount to be maintained
iii. Call money: Amount to deposited if balance below minimum
iv. Variation margin : Amount to paid/received on MTM basis
6. Forwards and Futures – Difference
a. Trading: Forward contracts are traded on personal basis or on telephone or otherwise.
Futures contracts are traded in a competitive arena.
b. Size of contract: Forward contracts are individually tailored and have no standardised
size.. Futures contracts are standardised in terms of quantity or amount as the case may
be.

7
c. Organised exchanges: Forward contracts are traded in an over the counter market. Futures
contracts are traded on organised exchanges with a designated physical location.
d. Settlement: Forward contracts settlement takes place on the date agreed upon between the
parties. Futures contracts settlements are made daily via exchange’s clearing house.
e. Delivery date: Forward contracts may be delivered on the dates agreed upon and in terms
of actual delivery. Futures contracts delivery dates are fixed on cyclical basis and hardly
takes place. However, it does not mean that there is no actual delivery.
f. Transaction costs: Cost of forward contracts is based on bid – ask spread. Futures
contracts entail brokerage fees for buy and sell orders.
g. Marking to market: Forward contracts are not subject to marking to market. Futures
contracts are subject to marking to market in which the loss profit is debited or credited in
the margin account on daily basis due to change in price.
h. Margins: Margins are not required in forward contract. In futures contracts every
participant is subject to maintain margin
7. Spot market Vs future market

a. Shares are traded in spot market where as lot sizes(contracts) are traded in future market
b. Price in spot market is called as Spot price and price in future market is called as future
price
c. There are no lot size in spot market whereas trading in future market should be in
multiples of lot size only
d. Both spot price and future prices are quoted today
e. Settlement date for spot market transaction is immediate whereas for future market it is
expiry date
f. Index trading in spot market is not possible, but possible in future market
7.2.1 Futures for Speculation
1. Meaning:
a. Futures can be used as a tool for mode of speculation depending on expectation of
investor
b. When a position is taken today say future buy and later will be square off . Difference
will be profit or loss
2. Position:
a. A person who is expecting share price to increase will take a long position today and later
will square off by selling it.
b. A person who is expecting share price to fall will take a short position today and later will
square off by buying it.
3. Profit or loss on future transaction = (Sell price) – (Buy price)* Lot size * No of contracts
7.2.2 Fair value of future under Cost of carry model
1. Meaning: This refers to the process of finding theoretical value of future instrument based its spot
price on a given date
2. Analysis of fair value of futures
a. Future segment is different from cash segment (spot market) since they vary in settlement
dates i.e at spot price settlement should be immediate, and future price is quote for

7
settlement at later date. Hence spot price and future price will not be same even though
the underlying share(underlying asset) is same. The only difference being time periods.
b. Hence, theoretically, Value of Future = Spot Price + Interest from date of transaction till
expiry date
c. Another view, If investment is sourced from borrowed money then price should be
increased at least by interest amount to compensate for the cost. If investment is out of
own resources, then price should yield at least risk free interest i.e opportunity cost.
3. Impact of dividend
a. If dividend is expected during the holding period, then it should be eliminated from future
price , since to that extent income is already realised. In other words, Future price should
be Ex-dividend price.
b. Hence dividend expected should be subtracted to arrive at fair value of futures
4. Formulae
a. Basic formulae: Fair value of future = Spot Price + Interest – Dividend
b. Using simple interest (no compounding)
Fair value of futures = Spot Price + Interest - Dividend
c. Using compound interest
Fair value of futures = (Spot Price – PV of Dividend)*(1+r)t
d. Using Continuous compounding
Fair value of futures = (Spot Price – PV of Dividend)*ert
e. In all the above formulae, r is risk free rate of interest/ opportunity cost and t reflect time
period from date of transaction to date of expiry
f. Commodity futures
i. Future contract where underlying asset is commodity like gold, oil etc
ii. Future = Spot + Cost of storage + Interest– Convenience Yield
iii. Only spot price will be in present value terms, cost of storage and yield will be in
future value terms unless otherwise specified
7.2.3 Arbitrage in futures
1. Meaning :
a. Arbitrage means the process of making riskless profit by taking position in two market
when the market prices are imperfect
b. Arbitrage in future means making certain profit by taking position in spot market and
future market when fair value of future is different from actual future price
2. Analysis
a. Value of futures and price of futures may not be same because of market factors. If not
equal there exists arbitrage opportunity subject to transaction cost. If no information
available in problems assume price= value
b. Spot price and future price are prices for same asset with different dates of settlement.
Hence difference between spot price and future price should essentially represent time
value of money.
c. When future value is different from future price, there exists arbitrage opportunity.
3. Tabular format for arbitrage
a. Future is over priced
Situation: Future Price > Fair value
Market Today At expiry

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Future Future Sell Future Buy

Spot Spot Buy Spot Sell
Money Borrow Repay
b. Future is under priced
Situation: Future Price < Fair value

Market Today At expiry
Future Future buy Future Sell
Spot Spot Sell Spot buy
Money Deposit Deposit matures
7.2.4 Hedging using Index futures
1. Meaning
a. Hedging Means the process of reducing or minimizing risk by taking appropriate position
like taking insurance policy, entering into forward sale agreement by manufacturer etc.
b. Hedging using Index future means a position is taken in Index futures for corresponding
portfolio investment
c. To have hedging ,there should be minimum two contracts. One causing the risk and the
other which can reduce/avoid the risk. In this case, portfolio investment is causing risk
situation and Index futures are used to minimize such risks
2. Hedging mechanism in general: In stock market, a long position in one investment should be
covered by short position in another investment so that results move in opposite direction.
Situations can be described as below
a. When market is up, Long position provides profit, short position provides loss
b. When market is down, Long position provides loss, short position provides profit, As a
result, loss is always compensated by other profit
3. Advantages of Index hedging
a. In general, investment will be in portfolio of shares. This needs to be covered by taking
position in another portfolio of shares. Most Effective and accepted portfolio is market
portfolio which is represented by Index like Nifty , Sensex etc
b. Transactions in Spot index is not possible due to limitation of physical delivery. Index
future transactions are settled without physical delivery and hence its convenient to use
such instruments
c. Index futures is highly liquid as compared to individual shares futures
4. Amount of hedging
a. It is not sufficient to invest equal amount in Portfolio and Index futures, since their risk
levels are different. Position should be taken in Index futures in such a way that the
impact of movements results in same amount of profit in one and loss in another.( in
portfolio and in index futures).
b. Risk level is measured by Beta. Beta of market portfolio(index) is always 1. Beta of
portfolio is computed by weighted average of beta of securities in the portfolio.
Position on Index futures Position on Portfolio

Amount on index futures*1 Amount of investment*Beta

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c. Amount of position based on Type of hedging

Type Amount of position to be taken on Index futures
Perfect hedging Portfolio Investment*Beta

Partial hedging Portfolio Investment*(Current Beta – Target beta)
No Hedging No position
d. Number of contracts to be entered in index futures = Portfolio Investment*Beta
Lot Size * Index value
5. Impact of Negative beta on hedging

a. Negative beta means movement of portfolio and index in opposite direction. Normally we
take long position on portfolio and short on futures so that impact is opposite. When beta
is negative, it is already in opposite direction hence no need to create that short position to
get opposite movements.
b. Beta of index is 1 which is positive and negative beta of portfolio results in profit in one
and loss in another.
c. Hence, to do hedging both portfolio and index needs to be long position
d. Amount of position to be taken on Index futures=Portfolio Investment*Beta
6. Why “perfect” hedging is not a reality: Complete hedged can’t be achieved in reality because of
following reasons.
a. Because of minimum Lot sizes, it may result in fractional number of contracts to be
taken, which implies wither more coverage or less coverage because of rounding off.
b. Beta is only a statistical measure of average. In reality, ratio of movements of portfolio
and index may not be accurately same as beta

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7.3 Options
1. DEFINITION OF 'OPTION'
a. Options are financial instruments that are derivatives based on the value of underlying
securities such as stocks. An options contract offers the buyer the opportunity to buy or
sell—depending on the type of contract they hold—the underlying asset. Unlike futures,
the holder is not required to buy or sell the asset if they choose not to.
2. Types
a. Based on period of expiry
i. An option that can be exercised only on expiry is called as European option
ii. An option that can be exercised any time before expiry is called as American
option
b. Types based on type of right
i. Call options : Where holder gets the tight to buy the underlying asset at a later
date
ii. Put options: Where holder gets the tight to sell the underlying asset at a later date
3. Terms in options
a. Option Holder
b. Option Writer
c. Option Premium
d. Underlying Asset
e. Strike Price
f. Exercise date
g. Option exercised :
h. Option lapse
i. Intrinsic value
j. Intrinsic value :
7.3.1 Call Options
1. Meaning:
a. Option to buy the share in future at a price today
b. It is an instrument or a contract which is signed today for a settlement at a later date at
fixed price called as strike price. and provides the holder right to buy the underlying asset
and put obligation on writer to sell the underlying asset.
c. Since holder enjoys the right of exercise, he pays option premium as consideration for
risk of obligation to the writer.
2. Features
a. That price decided today is called strike price
b. Person who buys call option is called Buyer/Holder (Has option to buy)
c. Person who sells call option is called Writer(Has Obligation to sell)
d. Holder gets the benefit of option to buy the asset and cost being payment of option
premium
e. Writer gets the benefit of receipt of option premium and cost being obligation to sell the
underlying asset
3. At expiry date,
a. Option is exercised if Market price > Strike Price

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b. If Market price of underlying asset > Strike price, holder will exercise the option
c. If market price of underlying asset < strike price, holder will not exercise the option.
d. Option premium is not relevant to make decision of exercise by holder.
e. Exercising means holder will buy the underlying asset at strike price and writer shall
oblige by selling it.
f. Difference between market price and strike price is called as intrinsic value of option.
Difference between intrinsic value and option premium is called as time value of money
or pay off to holder/writer.
g. When Market price > Strike price, it is called as “In the money “
h. When market price = Strike price, it is called as “ At the money”
i. When Market price < Strike price, it is called as “Out the money “
4. Other points related to call option

a. Since call option holder expects market price to increase, his sentiment is Bullish in
nature.
b. Call option holder pay off = MP-SP- Option premium
c. Break even point , MP = Strike Price + Option premium
d. Call option writer , pay off = Option premium –[MP- SP]
e. Break even point, MP = Strike Price + Option premium
f. Holder and writer will always have opposite impact of profit and loss. And over all it’s a
zero sum game.
7.3.2 Put options
1. Meaning:
a. Option to sell the share in future at a price today
b. It is an instrument or a contract which is signed today for a settlement at a later date at
fixed price called as strike price. and provides the holder right to sell the underlying asset
and put obligation on writer to buy the underlying asset.
c. Since holder enjoys the right of exercise, he pays option premium as consideration for
risk of obligation to the writer.
2. Features
a. That price decided today is called strike price
b. Person who buys call option is called Buyer/Holder (Has option to sell)
c. Person who sells call option is called Writer(Has Obligation to buy)
d. Holder gets the benefit of option to sell the asset and cost being payment of option
premium
e. Writer gets the benefit of receipt of option premium and cost being obligation to buy the
underlying asset
3. At expiry date,
a. Option is exercised if Market price < Strike Price
b. If Market price of underlying asset < Strike price, holder will exercise the option
c. If market price of underlying asset > strike price, holder will not exercise the option.
d. Option premium is not relevant to make decision of exercise by holder.
e. Exercising means holder will sell the underlying asset at strike price and writer shall
oblige by buying it.

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f. Difference between market price and strike price is called as intrinsic value of option.
Difference between intrinsic value and option premium is called as time value of money
or pay off to holder/writer.
g. When Market price < Strike price, it is called as “In the money “
h. When market price = Strike price, it is called as “ At the money”
i. When Market price > Strike price, it is called as “Out the money “
4. Other points related to put option

a. Since put option holder expects market price to decrease, his sentiment is bearish in
nature.
b. Put option holder pay off = SP- MP- Option premium
c. Break even point , MP = Strike Price - Option premium
d. Put option writer , pay off = Option premium –[SP- MP]
e. Break even point, MP = Strike Price - Option premium
f. Holder and writer will always have opposite impact of profit and loss. And over all it’s a
zero sum game.
7.3.3 Call option and put option summary
1. Under call option,

a. Holder will buy option today
b. Holder can buy the underlying asset at expiry date
c. Write will sell option today
d. Writer should sell underlying asset at expiry date at discretion of holder
2. Under put option
a. Holder will buy the option today
b. Holder can sell the underlying asset at expiry date
c. Write will sell option today
d. Write should buy the underlying asset at expiry date at discretion of holder
3. Various parties in options
a. Person who have the right to buy underlying asset is called as CALL OPTION HOLDER
b. Person who have obligation to buy the underlying asset is called as PUT OPTION
WRITER
c. Person who have right to sell the underlying asset is called as PUT OPTION HOLDER
d. Person who have obligation to sell the underlying asset is called as CALL OPTION
WRITER

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7.3.4 Option strategies
Strategy name Strategy

Straddle long Buy call option and buy put option with same maturity period and same
strike price
Straddle short Write call option and write put option with same maturity period and
same strike price
Strangle long Buy call option at higher strike price and buy put option at lower strike
price with same maturity period
Strangle short Write call option at higher strike price and write put option at lower
strike price with same maturity period
Bull spread with call Buy call option with lower strike price and write call option with higher
strike price
Bull spread with put Buy put option with lower strike price and write put option with higher
strike price
Bear spread with call Buy Call option with higher strike price and write call option with lower
strike price
Bear spread with put Buy put option with higher strike price and write put option with lower
strike price
Butterfly Spread with 3 Strike Prices, 4 Call options, Buy call option high strike price,Write
call 2call option middle strike price, Buy low call option strike price
Calendar spread with buying call option and selling call option at same strike price with
call different period
Calendar spread with buying put option and selling put option at same strike price with
put different period
7.3.5 Put call parity theorem
1. Link between price of underlying asset , put options call options and strike price.
2. Vc + PV of strike price = Vp + Current market price
3. If equation doesn’t hold good, there exists opportunity for arbitrage gain
4. Interpretation
a. Based on call option premium theoretical put option premium(value) can be computed
and vice versa.
b. Hold call and write put or hold put and write call
5. Arbitrage strategy
a. Today purchase call option (become call option holder) by paying premium since it is
under-priced.
b. At expiry assuming MP > SP, obtain delivery of shares by paying strike price. Such
shares shouldn’t be sold in spot market then because such price is not known today.
c. Instead, it can be disposed by way of repayment of shares. To create such repayment
position, borrow shares today.
d. After borrowing shares, that should be sold today in spot market at current market price.
At this stage sequence of transactions are as follows
e. Today :
i. Borrow Shares
ii. Sell shares in spot market
iii. Receive money on selling
iv. Deposit such receipts
v. Pay call option premium and become call option holder

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f. At expiry :
i. Deposit matures.
ii. Use deposit money and right of call option holder to buy the shares at strike price.
iii. Such shares to be used as repayment of borrowings done earlier.
iv. Transactions as listed above holds good when MP > SP in which case call option
would exercised.
v. If MP < SP at expiry, then call option wouldn’t be exercised.
vi. But you still require share because you under obligation to repay shares borrowed
earlier.
vii. Now shares cant be purchased from call option contract since its not exercised
and cant be purchased from spot market as well since market price is uncertain.
viii. Only other alternative is to write put option today so that its gets exercised at
expiry when MP<SP where you are under obligation to buy the shares. Writing
put option will not add any obligation when MP>SP since it won’t be exercised
by holder.
6. Arbitrage strategy summary table
a. Call option under-priced
Today At expiry
MP>SP MP<SP
Shares Borrow Repay Repay
Call option Buy Buy Shares at SP Option not exercised
Put option Sell Option not exercised Buy Shares at SP
Money Deposit Deposit matures Deposit matures
b. Call option over-priced
Today At expiry
MP>SP MP<SP
Shares Deposit Deposit matures Deposit matures
Call option Sell Sell Shares at SP Option not exercised
Put option Buy Option not exercised Sell Shares at SP
Money Borrow Repay Repay
7.3.6 Option valuation
1. It is the process of computing theoretical price(value) of option premium.

2. Objective of paying option premium is to recover it at expiry by ways of difference between
market price and strike price i,e intrinsic value.
3. Hence option premium is the present value of intrinsic value
4. Example,
a. Strike price is 100, Future price = 124
b. A person pays Rs.24 to get the right.
c. Another person who don’t buy the right.
d. After one year,
e. 1st Person : Cost of purchasing one share : 100+24 = 124
f. 2nd Person : Cost of purchasing one share : 124

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5. This situation where person having a position in option is equated with a person without having a
position is called as “principle of No arbitrage”
6. Factors affecting option valuation
a. Market Price(Because option value is based on intrinsic value )
b. Strike Price (Because option value is based on intrinsic value )
c. Risk free rate(Because option is PV of Intrinsic value)
d. Time to expiry(Because option is PV of Intrinsic value)
e. Probability and standard deviation (Range of movement of market price)
7.3.7 Binomial Model
1. Portfolio replication model

a. Assumptions
i. Future price can only be two numbers
ii. Construct portfolio without any risk
iii. Strategy is to have long position on underlying asset and short position on call
option
b. Replications possible
i. Long on shares and write call option
ii. Short on shares and hold call option
iii. Long on shares and hold put option
iv. Short on shares and write put option
c. Steps in calculation
d. Delta(No of shares)= High price – Strike Price
High price – Low Price
e. Value of call = Current portfolio - PV of risk free future portfolio
Current price* No of shares -PV of No of shares*Low Price
2. Risk neutrality model

a. Assumptions
i. Future price can only be two numbers
ii. Probability computed based on risk free interest
b. Steps in calculation
i. Step 1 : Compute Risk neutral Probability
P=F–L
H–L
ii. Step 2 : Expected Intrinsic Value

(H- SP)* P + (L-SP)*(1-P)
iii. Step 3 : PV of Expected Intrinsic Value
= Theoretical value of option premium
3. Two period binomial model

a. Steps
i. Compute risk neutral probability for a sub period
ii. Compute possible Market Prices at the end of expiry
iii. Compute PV of expected Intrinsic value

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1. Intrinsic values at expiry(4 values)

2. . Expected values at end of 1st period(2 values)
3. Option premium based on above expected values
7.3.8 Black-scholes model
1. The Black-Scholes model is used to calculate a theoretical price (ignoring dividends paid during
the life of the option) using the five key
2. Determinants of an option's price:
a. stock price, (S)
b. strike price, (x)
c. volatility, (Sd)
d. short-term (risk free) interest rate.(r)
e. time to expiration,(T)
3. The model makes certain assumptions, including:
a. The options are European and can only be exercised at expiration
b. No dividends are paid out during the life of the option
c. Efficient markets (i.e., market movements cannot be predicted)
d. No commissions
e. The risk-free rate and volatility of the underlying are known and constant
f. Follows a lognormal distribution; that is, returns on the underlying are normally
distributed.
4. Formula- Call option
a. 𝑽𝒄 = 𝑺 ∗ 𝑵(𝒅𝟏) − 𝒙 𝒆−𝒓𝒕 𝑵(𝒅𝟐)
𝑠 𝜎2
𝐼𝑛( )+(𝑟+ )𝑡
𝑥 2
b. 𝑑1 =
𝜎 √𝑡
c. 𝑑2 = 𝑑1 − 𝜎√𝑡
i. S = current stock price
ii. X = strike price of the option
iii. t = time remaining until expiration, expressed as a percent of a year
iv. r = current continuously compounded risk-free interest rate
v. 𝝈 = annual volatility of stock price (the standard deviation of the short-term
vi. returns over one year).
vii. ln = natural logarithm
viii. N(x) = standard normal cumulative distribution function
ix. e = the exponential function
5. Price of put option = xe-rtN(-d2)-SN(-d1)
7.3.9 The Greeks in option valuation
1. There are a lot of moving parts with options, but luckily, we have the greeks to help us parse the
information the market is giving us. There are five main greeks - Beta, Delta, Gamma, Theta and
Vega. Each have a different meaning and importance, but understanding them holistically helps
us analyze our portfolio and position risk. Greek values in options trading are extremely
important, as they allow us to have a mathematical understanding of our positions as well as
gauge our true risk.
2. Beta is the greek that allows us to weight our current positions with a designated benchmark.

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3. Delta is the rate of change of the option price with respect to the price of the underlying. Deltas
can be positive or negative. Deltas can also be thought of as the probability that the option will
expire ITM. Having a delta neutral portfolio can be a great way to mitigate directional risk from
market moves.
4. Gamma is the rate of change in the delta of an option. Gamma values are largest in ATM options,
and smallest in ITM and OTM options. Gamma sensitivity exponentially increases as expiration
nears. Gamma is important to keep in mind when hedging deltas because low gamma positions
require less maintenance than high gamma position.
5. Theta measures the rate of change in an options price relative to time. This is also referred to as
time decay. Theta values are negative in long option positions and positive in short option
positions. Initially, out of the money options have a faster rate of theta decay than at the money
options, but as expiration nears, the rate of theta decay for OTM options slows and the ATM
options begin to experience theta decay at a faster rate. This is a function of theta being a much
smaller component of an OTM option's price, the closer the option is to expiring.
6. Vega is the greek metric that allows us to see our exposure to changes in implied volatility. Vega
values represent the change in an option’s price given a 1% move in implied volatility, all else
equal

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7.4 Summary chart
Derivatives
3 conditions Examples
Value changes Initial investment Settled Futures
To change in
underlying Zero Or At future date Options
variable
Minimal As
compared to buy
underlying
Objectives
Speculation Hedging Arbitrage
Risk Taking advantage

Uncertain profit
management of imperfect
technique market price
Risk element Process of

reducing or Buy at cheaper
minimizing the price , sell at
uncertainty higher price

7
Basics
Long
Borrow
Money
Repay money Buy Shares
Receive
Hold Shares
Money
Sell Shares
Short
Borrow Shares
Repay Shares Sell shares
Receive Shares Deposit Money
Buy Shares
Position Long Short
Buy first and sell Sell first and buy

Definition
later later
Nature Bullish Bearish
When price is up Makes profit Makes Loss
When price is
Makes Loss Makes profit
down

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Futures
Futures
Settlement
Meaning Features Purposes
mechanism
Agreement Standard
Theoretical Practical Speculation Hedging Arbitrage
today Product
Settlement Initial Settlement Settlement Uncertain Minimize Riskless

at later date Margin by Delivery by net Profit risk profit in
(cash basis) market
Cash basis imperfectio
Today enter ns
Settlement into Today enter
agreement into future
buy,
Square off
Execute by At expiry
purchase square off
Month end /sale at by future
expiry expiry sell
Cash flow Settlement

at expiry on MTM
only basis (daily)
entering into
Initial Margin At the time of
contract
Variation MTM
Daily
margin settlement
Margin
Maintenance Minimum to be
Margin amount maintained
If balance
Amount to
goes below
deposited
minimum
Call money
Initial margin
Amount =
- actual

7
Speculation
Meaning Transactions
Uncertain profit Long Short
Future Buy Future Sell

today today
Square off
Square off
future buy
future sell later
tomorrow
Adjust for Adjust for

opportunity cost opportunity cost
on Margin on Margin
money money
Forward contract Vs future market
Particulars Forwards Futures
Trading Over the counter Stock exchange
Size individually tailored Standard size
Date of Settlement Any date Standardized date
Transaction costs Differs from case to case Standardized
Market to Market Don’t apply Apply
Margin Don’t apply Apply

7
Spot market Vs future market
Particulars Spot market Future market
Trading Of shares Of contracts
Price Spot Price Future price
Volume Any number Lot size
Price Quoted on Today Today
Price quoted for Purchase/sale today Purchase/sale later date
Settlement Delivery Cash basis
Index trading Not possible Possible

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Fair value of future under Cost of carry model
Spot price
=Spot Price+Risk
adjusted for time
free return
value of money
Basics
For the remaining

term to maturity
F= Spot Price +
Simple interest
Interest
Compound F= Spot Price (1+

Computation
interest r)t
Fair value
Continuous
F= Spot Price *ert
compounding
Negative impact
In general to compute Ex-
div Price
PV of Dividend is
Impact of Dividend per
subtracted from
dividend share
Sopt
r = risk free rate

Dividend yield %- dividend yield
%

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Arbitrage strategy(when future price ≠fair value of futures)
Arbitrage
Meaning Steps
Making use of Identify

Strategy Settlement
imperfect opportunity
market price
Fair value If Price < If Price > Difference in

Buy at ≠Future price Value Value Spot
cheaper
place(Spot/fut
ure)
Fair Value = Difference in
Under Priced Overpriced
Spot + Interest Future
Sell at costlier
– Div
place
(Spot/Future) Enter into Enter into Interest
For remaining Future Buy future sell paid/rec
time to
maturity
S: Shor S: Long
Net is
F: Long F : Short
arbitrage gain
M: Deposit M: Borrow
Situation: Future Price > Fair value Situation: Future Price < Fair value
Market Today At expiry Market Today At expiry
Future Future Sell Future Buy Future Future Buy Future Sell
Spot Spot Buy Spot Sell Spot Spot Sell Spot Buy
Money Borrow Repay Money Deposit Deposit Matures

7
Index futures for Risk Management(hedging)
Perfect hedging Partial hedging Speculation
Minimize risk(less Increase risk(High

Eliminate risk (β =0)
β) β)
No of Index futures = Portfolio Amt Portfolio Amt

Portfolio Value * Beta Lot (Current β *(Current β
* Fut. Index Price -Target β) -Target β)
Short position
Short position Long position
(Long if -β)
Index future hedging computation format

Today Later
if Index down by %, Portfolio %*beta
Spot Portfolio Amount Loss = Portfolio * Index %*beta
(Long)
Future No of contracts Profit = No of contracts*lot lize*Index

future price*%
=Portfolio*beta
Lot size*Index future Price
(Short)

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Options
Option
basics
Two
Two Two
Agreement instruemen Cash flows Types
parties positions
ts
Premium Right to
Entered One person
Holder Right at buy-Call
today gets right
inception option
One person
Settled on Underlying Strike Right to
Writer assumes
future asset price on sell- put
obligation
expiry date option
at the
option of
holder
Options
positions
Option Option
Holder writer
Buy the Pays Sell the Receive Assumes

Gets right
right Premium right premium obligation
Right to Right to obligation Obligatio

buy sell to sell n to buy
underlyin underlyin underlyin underlyin
g asset g asset g asset g asset
Call Put Call Put

option option option option
holder holder writer writer

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Call Options
Call options
On Expiry
MP>SP MP<SP MP=SP
Cheaper in Cheaper in Cheaper in

options Market Market
Option Option not Option not

exercised exercised exercised
Intrinsic value Intrinsic value Intrinsic value

= MP-SP =0 =0
Pay off = IV- Pay off = - Pay off = -

Premium Premium Premium
In the money Out the money At the money
Settlement in
Call option
On Delivery On Cash
MP> SP MP < SP MP> SP MP < SP
Purchased in
Purchased in Purchased in Option not
options and
Options Market exercised
sold in market
Intrinsic value Intrinsic value

= MP - SP is 0

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Pay off
Holder Writer
IV= MP-SP IV= MP-SP
Net = IV-Premium Net = Premium-IV
BEP MP=SP+Premium BEP MP=SP+Premium
Profit is unlimited Loss is unlimited
Loss is limited to Profit is limited to

premium premium
Put Options
Put options On
Expiry
MP>SP MP<SP MP=SP
Higher price in Higher price in Higher price in

Market options options
Option not Option Option

exercised exercised exercised
Intrinsic value Intrinsic value Intrinsic value

=0 = SP-MP = SP-MP
Pay off = - Pay off =IV - Pay off =IV -

Premium Premium Premium
Out the money In the money At the money

7
Settlement in
Put option
On Delivery On Cash
MP> SP MP < SP MP> SP MP < SP
Purchased in
Sold in Option not
Sold in market market and
Options exercised
sold in options
Intrinsic value Intrinsic value

=0 is SP-MP
Pay off
Holder Writer
IV= SP-MP IV= SP-MP
Net = IV- Net =

Premium Premium-IV
BEP , BEP ,
MP=SP- MP=SP-
Premium Premium
Profit is
Loss is limited
limited to SP-
to SP-premium
premium
Profit is
Loss is limited
limited to
to premium
premium

7
Particulars Call option Put option
Holder of option/Buyer
Right to buy Right to sell
of option
Writer of option/Seller
Obligation to sell Obligation to buy
of option
Exercised when MP>Strike Price MP<Strike Price
Break even future

Strike price + Premium Strike price - Premium
market price
Market sentiment of
Bullish Bearish
option buyer
Market sentiment of
Bearish Bullish
writer
Loss limited to
Profit unlimited
premium
Pay off of option buyer Loss limited to
Profit limited to Strike
premium
price - Premium
Profit limited to
Loss unlimited
premium
Pay off of option writer profit limited to
loss limited to Strike
premium
price - Premium
Computation format
SP: Strike Price
MP at expiry Intrinsic value Premium Pay off Holder Pay off writer
For Call , MP-SP IV-Premium Premium-IV
For Put ,SP-MP
Option strategies

7
Strik Strik Strik

Descripti Instr Instr Inst Maximum Maximum
Name e e e
on 1 2 r3 Profit loss
Price Price Price
Buy call
option
and buy
put Premium
Call Put
option on
Long optio optio
with Sam Sam Call+Premi
1 strangl n n Unlimited
same e e um on Put
e Hold Hold
maturity at strike
er er
period price
and same
strike
price
Write
call
option
and write
put Call Put
Premium on
Short option optio optio
Sam Sam Call+Premiu
2 strangl with n n Unlimited
e e m on Put at
e same write Writ
strike price
maturity r er
period
and same
strike
price
Buy call
option at
higher
strike
price and Premium
Call Put
buy put on
Long optio optio
option at High Low Call+Premi
3 straddl n n Unlimited
lower er er um on Put
e Hold Hold
strike between
er er
price strike price
with
same
maturity
period
Write
call
Call Put Premium on
option at
Short optio optio Call+Premiu
higher High Low
4 straddl n n m on Put Unlimited
strike er er
e write Writ between
price and
r er strike price
write put
option at

7
lower
strike
price
with
same
maturity
period
Buy call
option
with
lower Premium
Call Call (Higher
Bull strike on Call
optio optio Strike Price-
Spread price and Low High holder-
5 n n Lower Strike
with write call er er Premium
Hold write price)- Net
call option on call
er r Premium
with writer
higher
strike
price
Buy put
option
with
(Higher
lower
Put Put Strike
Bull strike Premium on
optio optio Price-
Spread price and Low High put writer-
6 n n Lower
with write put er er Premium on
Hold Writ Strike
put option put holder
er er price)- Net
with
Premium
higher
strike
price
Buy Call
option
with
(Higher
higher Premium on
Call Call Strike
Bear strike call option
optio optio Price-
Spread price and High Low writer-
7 n n Lower
with write call er er premium on
Hold write Strike
call option call option
er r price)- Net
with holder
Premium
lower
strike
price
Buy put
Premium
option Put Put (Higher
Bear on put
with optio optio Strike Price-
Spread High Low Holder-
8 higher n n Lower Strike
with er er Premium
strike Hold Writ price)- Net
put on put
price and er er Premium
writer
write put

7
option
with
lower
strike
price
3 Strike
Prices, 4
Call
options,
Buy call
option Premium on
Middle
high call option
Strike Price
Butterf strike Call Call Call Holder+Prem
- Low
ly price,Wri optio optio optio ium on call
High Low Midd Strike
9 spread te 2call n n n option
er er le Price- Net
with option Hold Hold Writ Holder-
Premium at
call middle er er er 2Premium on
Middle
strike call option
Strike Price
price, writer
Buy low
call
option
strike
price
3 Strike
Prices, 4
Put
options,
Buy Put
option Premium on
Middle
high Put option
Strike Price
Butterf strike Put Put Put Holder+Prem
- Low
ly price,Wri optio optio optio ium on Put
1 High Low Midd Strike
spread te 2Put n n n option
0 er er le Price- Net
with option Hold Hold Writ Holder-
Premium at
Put middle er er er 2Premium on
Middle
strike Put option
Strike Price
price, writer
Buy low
Put
option
strike
price
Put call parity theorem

7
Call option over priced
Call option under priced

7
Methods of option valuation
Methods of
valuation
Binomial Black Scholes

Method Model
Portfolio
Risk neutral
replication
Approach
approach
One period
binomial Model
Two Period
Binomial Model
Binomial Model
Portfolio replication approach
∆= (H-SP)
Step 1 Delta
(H – L)
VC= Today portfolio

Step 2 = ∆*CMP - PV of( ∆* L)
- PV of porfolio on low price
Risk neutrality model
p= F–L
Step 1 : Risk neutral Probability
H-L
PV of Expected Intrinsic Vc = (H- SP)* P + (L-SP)*(1-P)

Step 2: Value (1+r)
Two period binomial model

7
Black-scholes model
Formula- Call option

𝑽𝒄 = 𝑺 ∗ 𝑵(𝒅𝟏) − 𝒙 𝒆−𝒓𝒕 𝑵(𝒅𝟐)
𝑠 𝜎2
𝐼𝑛 (𝑥 ) + (𝑟 + 2 ) 𝑡
𝑑1 =
𝜎 √𝑡
𝑑2 = 𝑑1 − 𝜎√𝑡
S = current stock price

X = strike price of the option
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
𝝈 = annual volatility of stock price (the standard deviation of the short-term returns over one
year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function

7
The Greeks in option valuation
unit change in the

Delta
underlying
Change in Delta on
account of a unit
Gamma
change in the
underlying
Greeks in options
Vega change in volatility
Theta change in time
Rho change in interest rates

7
7.5 Problems
Problem No 1. Speculation using futures January 2021(8 Marks)
The price of March Nifty Futures Contract on a particular day was 9170. The minimum trading lot on
Nifty Futures is 50. The initial margin is 8 and the maintenance margin is 6%. The index closed at the
following levels on next five days:
Day 1 2 3 4 5
Settlement Price (Rs) 9380 9520 9100 8960 9140

(i) Mark to market cash flows and daily closing balances on account of
(a) An investor who has taken a long position at 9170
b) An investor who has taken a short position at 9170
(ii) Net profit/ loss on each of the contracts
Problem No 2. Stock lending mechanism January 2021(O)(8 marks)
Mr. A is holding 1000 shares of face value of Rs 100 each of M/s. ABC Ltd. He wants to hold these
shares for long term and have no intention to sell.
On 1st January 2020, M/s XYZ Ltd. Has made short sales of M/s. ABC Ltd.’s shares and approached
Mr. A to lend his shares under Stock Lending Scheme with following terms:
(i) Shares to be borrowed for 3 months from 01-01-2020 to 31-03-2020,
(ii) Lending Charges/Fees of 1% to be paid every month on the closing price of the stock quoted in
Stock Exchange and
(iii) Bank Guarantee will be provided as collateral for the value as on 01-01-2020.
Other Information:
(a) Cost of Bank Guarantee is 8% per annum,
(b) On 29-02-2020 M/s. ABC Ltd.’s share quoted in Stock Exchange on various dates are as follows:
Date Share Price in Share Price in

Scenario -1 Bullish Scenario -2 Bullish
01-01-2020 1000 1000
31-01-2020 1020 980
29-02-2020 1040 960
31-03-2020 1050 940
You are required to find out:

(i) Earning of Mr. A through Stock Lending Scheme in both the scenarios,
(ii) Total Earnings of Mr. A during 01-01-2020 to 31-03-2020 in both the scenarios,
(iii) What is the Profit or loss to M/s. XYZ by shorting the shares using through Stock Lending
Scheme in both the scenarios?
Problem No 3. Fair value computation
Data given below relates to Share price of X ltd

1. Spot price : 5500
2. Time period: two month
3. Interest rate 12% p.a

7
Find fair future price if

(i) No compounding
(ii) Compounded Monthly
(iii) Continuously compounded Given e0.02= 1.020201
(iv) Under the case (i) above compute the future price after 15 days and 30 days assuming spot price
on the above dates are 5600 and 5700 respectively
(Answer Hint :(i) 5610, (ii) 5610.55 (iii) 5611.11 (iv) 5684, 5757 )
Problem No 4. Fair value computation with multiple dividends RTP November 2012
Suppose that there is a future contract on a share presently trading at Rs 1000. The life of future
contract is 90 days and during this time the company will pay dividends of Rs 7.50 in 30 days, Rs
8.50 in 60 days and Rs 9.00 in 90 days.
Assuming that the Compounded Continuously Risk free Rate of Interest (CCRRI) is 12% p.a. you are
required to find out:
(a) Fair Value of the contract if no arbitrage opportunity exists.
(b) Value of Cost to Carry.
[Given e-0.01 = 0.9905, e-0.02 = 0.9802, e-0.03 = 0.97045 and e0.03 = 1.03045]
(Answer Hint : Rs 1005.96, Rs 5.96 )
Problem No 5. Fair value and speculation November 2019(N)(6 Marks), MTP June 2021
A future contract is available on R Ltd. that pays an annual dividend of Rs 4 and whose stock is
currently priced at Rs 125. Each future contract calls for delivery of 1,000 shares to stock in one year,
daily marking to market. The corporate treasury bill rate is 8%.
Required:
(i) Given the above information, what should the price of one future contract be ?
(ii) If the company stock price decreases by 6%, what will be the price of one futures contract ?
(iii) As a result of the company stock price decrease, will an investor that has a long position in one
futures contract of R Ltd. realizes a gain or loss ? What will be the amount of his gain or loss ?
(Ignore margin and taxation, if any)
(Answer Hint : (i) Rs 1,31,000, (ii) Rs 1,22,900, (iii) Amount of loss will be: Rs 8100)
Problem No 6. Fair value computation with multiple dividend yield RTP May 2012
On 31-7-2011, the value of stock index was Rs 2,200. The risk free rate of return has been 9% per
annum. The dividend yield on this Stock Index is as under:
Month Dividend Paid

January 2%
February 5%
March 2%
April 2%
May 5%
June 2%

7
July 2%
August 5%
September 2%
October 2%
November 5%
December 2%
Assuming that interest is continuously compounded daily, find out the future price of contract
deliverable on 31-12-2011.
Given: e0.02417 = 1.02446.e0.01583 = 1.01593
Problem No 7. Commodity futures RTP May 2011
The following information is available about standard gold.

1. Spot Price (SP) Rs. 15,600 per 10 gms.
2. Future Price (FP) Rs. 17,100 for one year future contract
3. Risk free interest Rate (Rf) 8.5%
4. Present Value of Storage Cost Rs. 900 per year
From the above information you are requested to calculate the Present Value of Convenience yield
(PVC) of the standard gold.
(Answer Hint : 739)

(PVC) of the standard gold.
Problem No 8. Arbitrage in futures

(6 Marks) (May 2004),(6 Marks) (November 2009)(M), MTP May 2015,RTP November 2018
The following data relate to Anand Ltd.'s share price:

• Current price per share Rs. 1,800
• 6 months future's price/share Rs. 1,950
Assuming it is possible to borrow money in the market for transactions in securities at 12% per
annum, you are required:
(i) To calculate the theoretical minimum price of a 6-months forward purchase; and
(ii) To explain arbitrate opportunity
a. Using Settlement by delivery
b. Using settlement by Net
(Answer Hint :42 )
Problem No 9. Hedging using Index futures RTP May 2017
Miss K holds 10,000 shares of IBS Bank @ 2,738.70 when 1 month Index Future was trading @
6,086 The share has a Beta (β) of 1.2. How many Index Futures should she short to perfectly hedge
his position. A single Index Future is a lot of 50 indices.
Justify your result in the following cases:
(i) When the Index zooms by 1%

7
(ii) When the Index plummets by 2%.
(Answer Hint : NIL)
Problem No 10. Hedging using commodity futures May 2019(N)(8 Marks), MTP May
2020,RTP November 2020,RTP November 2020(O)
A Rice Trader has planned to sell 22000 kg of Rice after 3 months from now. The spot price of the
Rice is Rs 60 per kg and 3 months future on the same is trading at Rs 59 per kg. Size of the contract is
1000 kg. The price is expected to fall as low as Rs 56 per kg, 3 months hence.
What the trader can do to mitigate its risk of reduced profit?
If he decides to make use of future market, what would be the effective realized price for its sale when
after 3 months, spot price is Rs 57 per kg and future contract price for 3 months is Rs 58 per kg?
(Answer Hint : Effective Selling Price (12,76,000/22000) 58/kg. )
Problem No 11. Hedging validation
X bought 5000 shares of IDLI ltd at Rs.200 on 29.9.2014

He wants to be covered till 31.12.2014.Given that Beta of shares 1.2 and Nifty futures currently
trading 1200
Compute profit/loss under the following situations on 31.12.2014

(i) Nifty raised to 1250 and stock to 230
(ii) Nifty down to 1150 and stock to 185
(Answer Hint : 100000,-25000)
Problem No 12. Index hedging with actual prices RTP November 2018
Laxman buys 10,000 shares of X Ltd. at a price of Rs 22 per share whose beta value is 1.5 and sells
5,000 shares of A Ltd. at a price of Rs 40 per share having a beta value of 2. He obtains a complete
hedge by Nifty futures at Rs 1,000 each. He closes out his position at the closing price of the next day
when the share of X Ltd. dropped by 2%, share of A Ltd. appreciated by 3% and Nifty futures
dropped by 1.5%.
CALCULATE the overall profit/loss to Ram?
(Answer Hint : Gain/ Loss = Rs 78,550 – Rs 90,000 = - Rs 11,450 (Loss))
Problem No 13. Index hedging with actual prices

RTP November 2013,RTP November 2015,RTP May 2016,MTP November 2014,MTP
November 2017, MTP May 2018
Data given below relates to an Index

1. BSE 5000
2. Value of portfolio Rs 10,10,000
3. Risk free interest rate 9% p.a.
4. Dividend yield on Index 6% p.a.

7
5. Beta of portfolio 1.5
Assume that a future contract on the BSE index with four months maturity is used to hedge the value
of portfolio over next three months. One future contract is for delivery of 50 times the index.
Calculate:
(i) Price of future contract.
(ii) The gain on short futures position if index turns out to be 4,500 in three months
(iii) Value of Portfolio using CAPM.
(Answer Hint : Rs 2,52,500, Rs 1,61,625, Rs10,31,487.25)
Problem No 14. Pay off call option
Construct Pay off of call option holder and call option writer from information given below.
• Option premium Rs.5
• Strike Price Rs.100
• Future price from 80 to 120 incremental of Rs.5 each
Problem No 15. Put option basics
Suresh bought a 3 month put option on Billcare shares on 31.12.2014 which is currently trading at
Rs.40 with strike price of 60 for a premium of Rs.2 . Determine whether option is exercised or not in
the following cases of spot price after 3 months i.e as on 31st March 2015
Case 1 2 3 4 5 6 7
Price as on 31st March 2015 40 45 50 55 60 65 70
Problem No 16. Call option and put option exercise
From the following data identify whether options are exercised or not
Future spot price Strike Price Type of option Exercised?
100 90 Call option

2000 2500 Call option
900 850 Put option
5000 5100 Put option
237 234 Call option
415 410 Put option
27 24 Call option
80 74 Call option
900 910 Call option
567 517 Put option
148 153 Put option
58 49 Call option
849 842 Call option
Problem No 17. Option speculation
Calculate profits and losses from the following transactions:

7
(i) Mr. X writes a call option to purchase share at an exercise price of Rs. 60 for a premium of Rs. 12
per share. The share price rises to Rs. 62 by the time the option expires.
(ii) Mr. Y buys a put option at an exercise price of Rs. 80 for a premium of Rs. 8.50 per share. The
share price falls to Rs. 60 by the time the option expires.
(iii) Mr. Z writes a put option at an exercise price of Rs. 80 for a premium of Rs. 11 per share. The
price of the share rises to Rs. 96 by the time the option expires.
(iv) Mr. XY writes a put option with an exercise price of Rs. 70 for a premium of Rs. 8 per share. The
price falls to Rs. 48 by the time the option expires.
(Answer Hint : 10,11.5, 11,-14)
Problem No 18. Option speculation May 2019(N)(8 Marks)
Mr. John established the following spread on the TTK Ltd.'s stock:
1. Purchased one 3-month put option with a premium of Rs 15 and an exercise price of Rs 900.
2. Purchased one 3-month call option with a premium of Rs 90 and an exercise price of Rs 1100.
TTK Ltd.'s stock is currently selling) at Rs 1000. Calculate gain or loss, if the price of stock of TTK
Ltd. –
(i) Remains at Rs 1000 after 3 months.
(ii) Falls to Rs 700 after 3 months.
(iii) Raises to Rs 1200 after 3 months.
Assume the size of option is 200 shares of TTK Ltd
(Answer Hint : Net loss = Rs 21000, Net gain = Rs 19,000, Net Loss = Rs 1,000)
Problem No 19. Option speculation May 2016(5 Marks)
Fresh Bakery Ltd.' s share price has suddenly started moving both upward and downward on a rumour
that the company is going to have a collaboration agreement with a multinational company in bakery
business. If the rumour turns to be true, then the stock price will go up but if the rumour turns to be
false, then the market price of the share will crash. To protect from this an investor has purchased the
following call and put option:
(i) One 3 months call with a striking price of Rs 52 for Rs 2 premium per share.
(ii) One 3 months put with a striking price of Rs 50 for Rs 1 premium per share.
Assuming a lot size of 50 shares, determine the followings:

(1) The investor's position, if the collaboration agreement push the share price to Rs 53 in 3 months.
(2) The investor's ending position, if the collaboration agreement fails and the price crashes to Rs 46
in 3 months time.
(Answer Hint : (i) Net Loss = - Rs 100 (ii) Rs50)
Problem No 20. Put call parity and arbitrage
Following information is available for 3 months call and put option of stock of CAT limited
• Spot Price of a stock Rs31
• Strike Price Rs 30
• Value of 3 month call Rs 3

7
• Value of 3 month put Rs 2.25

• Interest rate is 10% p.a compounded continuously
(i) Check whether put call parity exists If not construct arbitrage strategy
(ii) If the value of put option is Rs 1 reconstruct arbitrage strategy (Given e0.025= 1.0253)
(Answer Hint : 1.02, 0.27)
Problem No 21. Put call parity and arbitrage RTP May 2011
The following table provides the prices of options on equity shares of X Ltd. and Y Ltd. The risk free
interest is 9%. You as a financial planner are required to spot any mispricing in the quotations of
option premium and stock prices? Suppose, if you find any such mispricing then how you can take
advantage of this pricing position.
Share Time to Exercise price Share price Call Put price(Rs.)

exercise (Rs.) (Rs.) Price(Rs.)
X Ltd. 6 months 100 160 56 4
Y Ltd 3 months 80 100 26 2
(Answer Hint : Net Gain Rs. 12.97, Rs. 0.50 )
Problem No 22. Option valuation with various probabilities

November 2012(8 Marks), Nov 2018(O)(5 Marks),MTP May 2014, MTP May 2015,MTP May
2018, MTP November 2019
You as an investor had purchased a 4-month call option on the equity shares of X Ltd. of Rs 10, of
which the current market price is Rs 132 and the exercise price Rs150. You expect the price to range
between Rs 120 to Rs 190. The expected share price of X Ltd. and related probability is given below:
Expected Price (Rs) 120 140 160 180 190

Probability .05 .20 .50 .10 .15
Compute the following:

(i) Expected Share price at the end of 4 months.
(ii) Value of Call Option at the end of 4 months, if the exercise price prevails.
(iii) In case the option is held to its maturity, what will be the expected value of the call option?
(Answer Hint : (1) Expected Share Price = Rs160.50 (2) Value of Call Option = Nil (iii) Value of Call
Option = Rs14 )
Problem No 23. Option valuation with various probabilities MTP May 2016
A call option has been entered into by Arnav for delivery of share of X Ltd. at Rs. 460. The expected
future prices at the time of expiry of contract are as follows:
Price (Rs.) Prob.

470 0.20
450 0.25
480 0.35

7
490 0.05
500 0.15
Determine the premium at which Arnav will break even

Problem No 24. Portfolio replication approach
From information below compute value of call option and put option using binomial model
• Spot price 100,
• Strike price 97,
• Future selling price may be 90 or 108
• Term 3 months,
• Interest rate 12% compounded continuously. Given e0.03 = 1.03045
(Answer Hint : Vc = 7.73 , Vp = 1.86 )
Problem No 25. Option hedging

November 2015(5 Marks), MTP May 2018, MTP November 2018, MTP May 2021
Mr. Dayal is interested in purchasing equity shares of ABC Ltd. which are currently selling at Rs 600
each. He expects that price of share may go upto Rs 780 or may go down to Rs 480 in three months.
The chances of occurring such variations are 60% and 40% respectively. A call option on the shares
of ABC Ltd. can be exercised at the end of three months with a strike price of Rs 630.
(i) What combination of share and option should Mr. Dayal select if he wants a perfect hedge?
(ii) What should be the value of option today (the risk free rate is 10% p.a.)?
(iii) What is the expected rate of return on the option?
(Answer Hint : (i) Mr. Dayal should purchase 0.50 share for every 1 call option. (ii) P = Rs65.85 (iii)
Expected Rate of Return = 36.67%)
Problem No 26. Risk neutral probability

May 2012(8 Marks),MTP November 2012,RTP November 2017, MTP November 2018
Sumana wanted to buy shares of ElL which has a range of Rs 411 to Rs 592 a month later. The
present price per share is Rs 421. Her broker informs her that the price of this share can sore up to Rs
522 within a month or so, so that she should buy a one month CALL of ElL. In order to be prudent in
buying the call, the share price should be more than or at least Rs 522 the assurance of which could
not be given by her broker.
Though she understands the uncertainty of the market, she wants to know the probability of attaining
the share price Rs 592 so that buying of a one month CALL of EIL at the execution price of Rs 522 is
justified.
Advice her. Take the risk free interest to be 3.60% per month and e0.036 =1.037
(Answer Hint : probability of rise in price 0.1418)

7
Problem No 27. Valuation using Risk neutral probability

May 2011(5 Marks),RTP May 2013, MTP November 2018
The current market price of an equity share of Penchant Ltd is Rsr420. Within a period of 3 months,
the maximum and minimum price of it is expected to be Rs 500 and Rs 400 respectively.
If the risk free rate of interest be 8% p.a., what should be the value of a 3 months Call option under
the “Risk Neutral” method at the strike rate of Rs 450 ? Given e0.02 = 1.0202
(Answer hint : Rs.13.96)
Problem No 28. Two period binomial model
Following information is available for 3 months call and put option of stock of CAT limited
• Strike Price Rs.25,
• Current Market Price Rs.20,
• Contract period 2 Year
• Rate of interest 10% p.a
• Price are expected to move in rage of + 20% p.a for both years.
Compute value of call option and put option
(Answer Hint : Vc = 1.77, Vp = 2.43)
Problem No 29. Black Scholes model RTP May 2010,RTP May 2020, MTP May 2020
From the following data for certain stock, find the value of a call option:
• Price of stock now = Rs.80
• Exercise price = Rs.75
• Standard deviation of continuously compounded annual return= 0.40
• Maturity period = 6 months
• Annual interest rate = 12%
Given
Number of S.D. from Mean, (z) Area of the left or right (one tail)
0.25 0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2578
0.12x0.05
e = 1.0060
In 1.0667 = 0.0645
(Answer Hint : = Rs13.96)
Problem No 30. Black Scholes model November 2008(12 Marks),RTP November 2011
Following information is available for X Company’s shares and Call option:
• Current share price Rs185

• Option exercise price Rs170
• Risk free interest rate 7%
• Time of the expiry of option 3 years

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• Standard deviation 0.18

• Calculate the value of option using Black-Scholes formula.
Given
• Ln 1.0882 = 0.08452
• N(1.101) = 0.8770
• N(0.789) = 0.7848
• e0.21 = 1.2336
(Answer Hint : Rs54.09 )

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FOREIGN EXCHANGE RISK

MANAGEMENT
Marks distribution

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8.1 Basic terminologies

1. Foreign currency market
a. Market where currencies are bought and sold
b. Both commodities are currencies. Somes times they are referred as Price currency and
base currency
c. A foreign exchange rate is the price of one currency expressed in terms of another
currency. Currency is exchanged for currency at a rate called as conversion rate.
d. Usually a higher priced currency will be quoted as one unit on left hand side
2. Currency risk
a. Movements of conversion rates uncertain is called currency risk.
b. Rates fluctuates due to various factor attributable to supply and demand in market
3. Conversion rates a based-on time period
a. Spot rate : It is the conversion rate to be paid today for immediate settlement
b. Forward rate It is the conversion rate agreed today for a settlement at a later date
4. Types of Exposures
a. Transaction exposure: Impact of setting outstanding obligations entered into before
change in exchange rates but to be settled after the change in exchange rates
b. Translation exposure: Accounting-based changes in consolidated financial statements
caused by a change in exchange rates
c. Operating exposure Change in expected cash flows arising because of an unexpected
change in exchange rates
5. Direct quote and Indirect quote
a. A foreign exchange quotation can be either a direct quotation and or an indirect quotation,
depending upon the home currency of the person concerned.
b. A direct quote is the home currency price of one-unit foreign currency. For example, the
quote $1 =Rs50.00 is a direct quote for an Indian point of view
c. An indirect quote is the foreign currency price of one unit of the home currency. The
quote Re.1 =$0.02 is an indirect quote for an Indian. ($1/Rs 50.00 =$0.02)
d. Direct and indirect quotes are reciprocals of each other, which can be mathematically
expressed as Direct quote = 1/indirect quote and vice versa
6. Bid, Offer and Spread
a. The bid price is the rate at which the bank will buy the base currency from a customer.
(Bid: Bank buying, Customer sell)
b. The offer price is the rate at which the banker will sell the base currency to a customer
(Offer: Bank Selling, Higher Customer buy)
c. In general, Customer will always be at a disadvantage position
i. He will buy at a higher price (Offer)
ii. He will sell at a lower price (Bid)
d. Transaction by Bank
i. When Bank is dealing with its customer, bank will be at advantage position
ii. When Bank is dealing with other bank (Interbank) or in market, then bank will be
at disadvantage position
e. Difference between Bid and offer rate is called as spread
7. Concept of Margin
a. If customer is buying, then effective buying rate =Offer rate + Margin %

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b. If customer is selling , then effective selling rate= Bid rate – Margin%

c. When Bank is transacting with customer: Margin money is applicable
d. When Bank is transacting with other bank in interbank or in market, margin is not
applicable
8. Foreign exchange positions
a. A dealer will always have two position in foreign exchange market
i. One transaction with customer – referred as Transaction rate or Forward rate in
forward market
ii. Corresponding another transaction or forward contract in interbank market as
“cover rate”
9. Inter bank Deals
a. Foreign exchange transactions involves transaction by a customer with the bank while
inter bank deals refer to purchase and sale of foreign exchange between banks.
b. In other words, it refers to the foreign exchange dealings of a bank in inter bank market.
10. Cover Deals
a. The banks deal with foreign exchange on behalf of its customers. Purchase and sale of
foreign currency in the market undertaken to acquire or dispose of foreign exchange
required or acquired as a consequence of its dealings with its customers is known as the
‘cover deal’. In this way that is through cover deal the bank gets insured against any
fluctuation in the exchange rates.
b. While quoting a rate to the customer the bank is guided by inter bank rate to which it adds
or deducts its margin, and arrives at the rate it quotes to the customer.
c. For example, if its is buying dollar from the customer special it takes inter bank buying
rate, deducts its exchange margin and quotes the rate. This exercise is done on the
assumption that immediately on purchase from customer the bank would sell the foreign
exchange to inter bank market at market buying rate.
d. Foreign currency is considered as peculiar commodity with wide fluctuations price, the
bank would like to sell immediately whatever it purchases and whenever it sells, it
immediately tries to purchase so that it meets it is commitment. The main reason for this
is that the bank wants to reduce exchange risk it faces to the minimum. Otherwise, any
adverse change in the rate would affect its profits.
e. In the case of spot deals the transaction is quite simple. If the bank purchased any foreign
exchange, it would try to find another customer to whom it can sell this and thus books
profit. In this process the profit would be the maximum because both buying and selling
rates are determined by the bank and the margin between the rates is the maximum. If it
cannot find another customer its sells in inter bank market where the rate is determined by
the market conditions and the margin is narrower here.

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8.2 Cross rates

1. Meaning:
a. It is the exchange rate which is expressed by a pair of currency in which none of the
currencies is the official currency of the country in which it is quoted.
b. The cross rate is the currency exchange rate between currency A and currency C
derived from exchange rate between currency A and currency B and between
currency B and currency C. Exchange rate between two currencies using third
common currency is called cross rates
c. When executing trades between the major currencies, the process is usually quick and
easy. However, when your trades involve currencies that are less common,
transactions are not always easy because the rates are not always quoted making it
difficult to trade exotic currencies without establishing an appropriate rate of
exchange. This rate is called the cross currency rate
2. Objective
a. Necessity : When exchange rate between two currencies are not available :
b. Arbitrage opportunity : When cross rates offer better rates than straight rates
3. Computation process
a. Exchange rate is expressed between two currencies at time and later both are multiplied to
get final exchange rate
b. Example Rupee / Euro= Rupee * Dollar
Dollar Euro

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8.3 Forward Market

1. Meaning
a. Forward Market is the place where agreement are entered today for a delivery at a later
date for price which is fixed today called as forward rate.
b. When there is agreement to sell the foreign currency, it is called as forward sale .
Similarly when there is agreement to buy the foreign currency it is called as forward buy.
2. Purposes of forward agreement.
a. Hedging: To cover foreign exchange fluctuation risk by entities such as exporters,
importers, borrowers etc
b. Speculation: To take advantage of fluctuation in foreign currency exchange rates by
entities such as foreign exchange dealers, banks etc.
3. Computation Premium or Discount (Expressed in % p.a)
a. When forward rate is higher than spot rate, it is called as “trading at premium”.
b. When forward rate is lower than spot rate it is called as “ Trading at discount”
c. Forward Premium/Discount= Forward Rate - Spot rate * 100 *12
Spot rate No of months
i. If result is positive, then premium
ii. If result is negative, then discount
d. Alternative view
i. Forward Premium/Discount =Forward Rate - Spot rate * 100 *12
Average rate No of months
4. Forward rate quotation using Swap points
a. Swap points are difference between spot rate and forward rate
b. Forward rate = Spot rate + swap points
c. Swap points are added when currency is trading at premium
d. Swap points are subtracted when currency is trading at discount.
e. When Swap points are in ascending order, currency is trading at premium.
f. When Swap points are in descending order, currency is trading at discount.
g. Example
i. Spot rate1USD = 60 INR
ii. SWAP Point is 2 and USD is expected to be premium
iii. Forward rate = Spot + SWAP = 60+ 2 = 62
h. Example
i. Spot rate: 1 USD = 60.25 – 30
ii. Swap points 2/3
iii. Forward rate = 1 USD = 60.25 +2 = 60.27 and 60.30+3 = 60.33
iv. If Swap points 3/2
v. 1 USD = 60.25 – 3 = 60.22 and 60.30- 2 = 60.28
i. Swap points summary
i. Points to be added/subtracted on spot rate to obtain forward rate
ii. Add /subtract from right to left in decimals
iii. If points are ascending then add, if descending then subtract
5. Depreciation and appreciation of currencies
a. Appreciation means a currency becoming more costlier. Example 1USD = 50 Rs has
become 1USD = 60Rs. In this case USD is said to be appreciated by 60-50/50*100 =

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20%. In case of appreciation a person having receivable position(exporter) will enjoy

benefits and a person having payable position(importer) will suffer loss
b. Depreciation means a currency becoming cheaper. In this case a person having receivable
position(exporter) will suffer loss and a person having payable position(importer) will
enjoy benefits.
c. When Foreign currency appreciates, the local currency will depreciate and vice versa, but
the magnitude of change will not be same because of mathematical reasons
d. When one currency is appreciated then % of appreciation to be applied on other currency.
For example if 1 USD = 50 Rs and USD is appreciated by 10%, then appreciation of 10%
is applied on Rs i.e 50*10% = 5 and total rate becomes 50+5 =55 or 50*110% = 55

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8.4 Purchasing power parity

1. Basics
a. It states the low of one price for a commodity in two countries
b. As per this theorem, purchasing power of any two currencies should be same.
c. It implies, currency may be having difference exchange rates, but they should be capable
of buying equal amount of products/services.
2. Purchasing power parity in spot market
a. Theory
i. The conversion rates in the implied rate between the two currencies based on
their ability to purchase the common product.
ii. If implied rate is different from actual conversion rate, then one currency is cheap
and another is costlier
b. Example
i. Basic data
1. If 1$ = 50 Rs.
2. 50 Rs can buy one book
3. 1$ can buy one book.
ii. Analysis
1. 1$ and 50 Rs will have same value since both have purchasing power of
one book.
2. If not equal i.e both currencies don’t have equal purchasing power, then
there exists arbitrage opportunity.
3. In the above example, if one book cost 2$ instead of 1$, then purchasing
power of Rs will be higher than purchasing power of $. In such case
following riskless strategy can be adopted,
a. Opportunity: Rs is cheaper as compared to $
b. Strategy: Buy in India(Rs) and sell in US ($)
c. Transactions:
i. Borrow 50 Rs. In India
ii. Using above money, buy one book
iii. Sell the above book in US for 2$
iv. Convert 2$ into Rs, you will receive 2$*50 =100 Rs.
v. Repay the borrowings of 50Rs
vi. Balance on hand = 100Rs- 50Rs = 50Rs
vii. Riskless profit/Arbitrage gain = 50 Rs
3. Impact of Purchasing power parity on forward rates.
a. Theory
i. On any given date, purchasing power of two currencies should be same.
ii. At later date, after considering the inflation also, their respective purchasing
power should be same.
b. Example,
i. Basic data
1. Spot rates In India 1 Book = 50 Rs.
2. SPot rates in US 1 Book = 1$
3. Implied Spot rate , 1$ = 50Rs = 1 Book
4. After 1 year, assume inflation in India 10% and in US 5%

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5. In India, 1 Book = 55Rs

6. in US 1 Book = 1.05$
ii. Analysis:
1. Applying purchasing power parity , implied exchange rate after one year
2. 1.05$ = 55Rs = 1 Book
3. 1$ = 55/1.05
4. 1$ = 52.38
iii. Summary of above: If spot rate is 1$ = 50 Rs, and expected inflation rate in one
year are 5% in US and 10% in India, then expected exchange rate after one year
should be 52.38(Implied forward rate)
4. Summary of purchasing power parity
a. Spot exchange rate is determined by prices of products in two countries or currencies.
b. Forward rate is determined by forward prices of products in two countries which is
determined by respective inflation rates.
c. Product in Foreign =Product in Local
d. Foreign Currency = Spot rate
e. After inflation
f. Foreign Currency(1+Foreign inflation) = Spot rate(1+local Inflation)
Forward rate as PPPT = Spot rate * (1+ Local inflation rate)
(+ foreign inflation rate)
g. Hence, As per PPPT, even with different inflation rates and with different currencies their
purchasing power of products should be same.
h. If not same i.e forward rate computer as per PPPT is not same as Actual forward rate
quoted by banks/dealers then there exists arbitrage opportunity.
i. Currency having lower inflation rate will be traded at premium because purchasing power
and inflation are inversely proportional.
j. If this theorem doesn’t hold good, there exists arbitrage opportunity

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8.5 Interest rate parity theory

1. Meaning
a. A county may have same inflation but carry different risk hence interest to be considered
instead of inflation rate
b. Interest rate consider premium for risk factor (Like a company issuing bond with lower
rating should offer higher interest rate)
c. Forward rate is fixed such a way that a person should be indifferent to
borrowing/investing between two countries
d. Foreign Currency = Spot rate
Compounded by Foreign interest rate= Compounded by local interest rate
Foreign Currency(1+Foreign interest rate) = Spot(1+Local interest rate)
Forward rate = Spot * ( 1 + Local interest rate)
1 + Foreign interest rate
e. If actual forward rate is different, then borrowing/investing in one of the currencies
becomes beneficial creating scope for arbitrage advantage
2. Analysis
a. When IRPT holds good, borrowing or investing in any country would be same
(Indifferent to different currencies).
b. Advantage in one will be offset by disadvantage in another.
c. For example
i. If foreign borrowing is cheaper than local borrowing , interest cost is saved which
is profit in money market but forward rate would have been increased at the time
of repayment which is loss in currency market
d. For borrower,: Profit in money market = Loss in currency market( Set off of profits and
losses)
e. For Investor : Loss in money market = Profit in currency market(Set off of profits and
losses)
3. Interest risk Vs Currency risk
a. Country with lower interest rate will have premium currency
b. Country with higher interest rate will have discounted currency
4. Example
a. A company needs Rs.100,000 for its business purpose. Spot rate today 1$ = 50Rs. Interest
rate in INR is 10% and in USD is 5%.
b. Forward rate as per IRPT = 50(1+0.10) = 52.3809
(1+0.05)
c. If borrowed in India, repayable after one year, 100,000 * (1+0.10) = 110,000 Rs
d. If borrowed in US, repayable after one year,
1. borrowings in USD 100,000/50 = 2000$
2. 2000$(1+0.05) = 2100$
3. Payable in Rupees= 2100*52.3809 = 110,000 Rs
e. Borrowing in any one country is not advantageous i.e indifferent to borrowing in different
currencies when IRPT holds goods.
f. If actual forward rate is different, then borrowing/investing in one of the currencies
becomes beneficial creating scope for arbitrage advantage
g. Interest rate differential = 10%- 5% = 5%
h. Forward premium = 52.3809 – 50 = 4.76%

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50
5. Steps in Arbitrage Using currency market

a. Determine Foreign currency and local currency
b. Find forward rate using IRPT
c. Sell the foreign currency if overpriced, Buy the foreign currency if under-priced
d. If forward foreign currency is over priced,
Today Later
Buy Spot Buy $
sell Forward sell $ Sell $ using forward contract
Borrow Borrow Rs Repay Rs Borrowings
Deposit Deposit $ Deposit $ Matures
Excess cash on hand is arbitrage gain
e. If forward foreign currency is under priced
Today Later
Buy Spot Sell $
sell Forward buy $ Buy $ using forward contract
Borrow Borrow $ Repay $ Borrowings
Deposit Deposit Rs Deposit Rs Matures
f. Fundamental Rule
i. Borrow and deposit should happen in different currencies
ii. Spot buy means forward sell and vice versa

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8.6 Foreign currency exposure hedging

1. Meaning :
a. It is the Process of avoiding or minimizing the impact of fluctuation of foreign exchange
rates on entities that deal in transactions involving multiple currencies, like borrower,
importer, investor, exporter etc.
b. Hedging is not for the purpose of making profit , but only to ensure cash flow is certain
from future transactions
2. Objective
a. For importer, to make his outflow certain
b. For exporter, to make his inflow certain
3. Strategies available
a. Forward cover
b. Money Market
c. Netting
d. Leading
e. Lagging
f. Foreign currency options
g. Foreign currency futures
h. Currency swap

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8.6.1 Forward cover or Forward hedging
1. Meaning : Currency exposure is reduced or avoided by entering into forward contract in which
date of settlement and conversion rate is pre-determined
2. Type of forward contracts
a. An importer will enter into forward buy
b. An exporter will enter into forward sell
3. Cost of hedging
a. Notional loss or profit between forward rate and actual spot rate on date of settlement
b. Premium paid if any in advance
c. Interest on premium paid if any for time value of money
8.6.2 Money Market Hedging
1. Meaning : Using money market i.e process of borrowing and lending to make cash flow certain
2. Types
a. Money market hedging for exporter
b. Money market hedging for importer
3. Fundamental Rule
a. Borrow and deposit should happen in different currencies
b. Spot buy means forward sell and vice versa
4. Money Market Hedging (Being an Exporter)
a. Basics
i. An exporter Needs to liquidate the foreign currency that he receives from his
customer after credit period.
ii. One alternative is to sell such foreign currency in spot market, which is uncertain
in nature. ( Spot market :Unhedged Position)
iii. Other alternative is to sell such foreign currency in forward market at forward
rate using the contract entered earlier. (Forward Hedging)
iv. Another alternate is dispose off such foreign currency for repaying the loan
which was taken earlier. (Money market hedging)
v. Hence, Money market Hedging is the process of making cash flow certain to
exporter by ways of foreign currency borrowing and to importer by way of
foreign currency deposit.
b. Steps
i. Borrow in foreign currency = Present value of Invoice amount using borrowing
interest in foreign currency.
ii. Sell the above borrowed amount in spot market to convert into local currency
using spot sell rate.
iii. Deposit the above local currency which matures after credit period along with
interest . Interest rate applicable is local currency deposit rate.
iv. Amount obtained under step 3 is net cash inflow for exporter
5. Money Market Hedging (Being an importer)

a. Deposit in foreign currency = Present value of Invoice amount using deposit interest in
foreign currency.
b. Purchase the above foreign currency deposit amount in spot market .

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c. Amount required to purchase the foreign currency above borrow in local currency which
will be repaid along with interest after credit period. Interest rate applicable is local
currency borrowing rate
d. Amount obtained under step 3 is net cash outflow for importer
8.6.3 Supplier credit Vs Bank Credit
1. It is the decision to be made from importer point of view. An importer will have two alternatives
to make the payment.
2. Alternatives
a. Alternative 1 : Use Supplier credit(Using foreign currency loan) i.e Make payment in
foreign currency after credit period along with interest charged by supplier
b. Alternative 2 : Use Bank Credit (Using local currency loan) i.e Make payment
immediately using loan from bank. And repay it after credit period along with interest
charged by banker
3. Steps in making decision on Supplier credit Vs Bank Credit.
a. Cash flow under Supplier credit
i. Invoice amount in foreign currency
ii. Add Interest charged by supplier for credit period
iii. Total amount payable in Foreign currency = (a+b)
iv. Total amount payable in local currency = (c) * Forward exchange rate
4. Cash flow under Bank Credit
a. Invoice amount in foreign currency
b. Amount payable in local currency (a) * Spot exchange rate
c. Add interest charged by banker for credit period
d. Total amount payable in local currency = (b) + (c)
8.6.4 Local borrowing Vs foreign borrowing
1. Basics
a. A business may need foreign currency for its financing purposes either at present or in
futures.
b. The financing need can be fulfilled by two alternatives
i. Borrow in foreign currency and use it for business purposes
ii. Borrowing local currency required to buy foreign currency from the spot market
and use it for business purposes
2. Evaluation of types of borrowings
a. Interest rate differential method
i. Compute Forward premium for foreign currency (Cost)
ii. Compute interest rate differentials between foreign borrowing and local
borrowing (Benefit)
iii. If forward premium is more, then foreign borrowing is costlier, and hence local
borrowing is recommended
iv. If forward premium is less, then foreign borrowing is cheaper, and hence Foreign
borrowing is recommended
b. Value method
i. Value of foreign borrowing = (1+ foreign Borrowing) (1+forward premium)

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ii. Value of rupee borrowing = (1+ local borrowing)

iii. Choose whichever is cheaper
8.6.5 Netting, leading and lagging
1. It is the process of setting of receivables in foreign currency with payable in foreign currency.
2. When an entity has exposure into both receivable and payable in foreign currency, they end up in
paying transaction cost such as margin, brokerage, spread etc two times. i.e on buying as well as
selling. This can be saved through netting mechanism.
3. However, the receivables and payables may not match on specific time periods. In such cases,
mechanism of leading and lagging is adopted to make receivables and payables happen on same
point in time so that netting can be done.
4. Leading means paying supplier in advance or receiving from customer in advance
5. Lagging means paying supplier late or delaying the receipt from customer.

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8.7 Forward contract disposal

1. Execution of Forward Contract
a. Basics
i. A customer under forward contract knows in advance the time and amount of
foreign exchange to be delivered and the customer is bound by this agreement.
There should not be any variation and on the due date of the forward contract the
customer will either deliver or take delivery of the fixed sum of foreign exchange
agreed upon.
ii. But, in practice, quite often the delivery under a forward contract may take place
before or after the due date, or delivery of foreign exchange may not take place at
all.
iii. The bank generally agrees to these variations provided the customer agrees to
bear the loss, if any, that the bank may have to sustain on account of the
variation.
b. Though the delivery or take delivery of a fixed sum of foreign exchange under a forward
contract has to take place at the agreed time, quite often this does not happen and it may
either take place before or after the due date agreed upon.
c. However, the bank generally agrees to these variations provided the customer bears the
loss if any on account of this variation.
d. Based on the circumstances, the customer may end up in any of the following ways:
i. Delivery on the due date.
ii. Early delivery.
iii. Late delivery.
iv. Cancellation on the due date.
v. Early cancellation.
vi. Late cancellation.
vii. Extension on the due date.
viii. Early extension.
ix. Late extension.
e. As per the Rule 8 of FEDAI, a request for delivery or cancellation or extension of the
forward contract should be made by the customer on or before its maturity date.
Otherwise a forward contract which remains unutilized after the due date becomes an
overdue contract. Rule 8 of FEDAI stipulates that banks shall levy a minimum charge of
Rs. 100 for every request from a merchant for early delivery, extension or cancellation of
a forward contract. This is in addition to recovery of actual loss incurred by the bank
caused by these changes.
2. Delivery on Due Date
a. This is the situation envisaged when the forward contract was entered into.
b. When the foreign exchange is delivered on the due date, the rate applied for the
transaction would be the rate originally agreed, irrespective of the spot rate prevailing.
3. Early Delivery
a. When a customer requests early delivery of a forward contract, i.e., delivery before its
due date, the bank may accede to the request provided the customer agrees to bear the
loss, if any, that may accrue to the bank.
b. Example

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i. On 1st May, the bank makes a spot purchase and forward sale of the same
Currency for the same value. The difference between the rate at which the
currency is purchased and sold in a swap deal is the swap difference.
ii. The swap difference may be a ‘swap loss’ or ‘swap gain’ depending upon the
rates prevailing in the market. If the bank buys high and sells low, the differences
Swap loss recoverable from the customer. It the bank buys low and sells high, the
difference is the swap gain payable to the customer.
iii. On 1st May, the bank receives rupees from the customer on sale of foreign
exchange to him. It pays rupees to the market for the spot purchase made. If the
amount paid exceeds the amount received, the difference represents outlay of
funds. Interest on outlay of funds is recoverable from the customer from the date
of early delivery to the original due date at a rate not lower than the prime lending
rate of the bank concerned.
iv. If the amount received exceeds the amount paid, the difference represents inflow
of funds. At its discretion, the bank may pay interest to the customer of inflow of
funds at the appropriate rate applicable for term deposits for the period for which
the funds remained with it.
c. Charges for early delivery will comprise of:
i. Swap difference;
ii. Interest on outlay of funds; and
iii. Flat charge (or handling charge) Rs. 100 (minimum).
d. Important Note:
i. In the deal with its customer the bank is the ‘market maker’ and the transaction is
talked of as ‘purchase’ or ‘sale’ from the bank’s point of view. When the bank
deals with the market, it is assumed that the market is the ‘mark maker’.
ii. Therefore, the market rates are interpreted with the market ‘buying’ ‘selling’ the
foreign exchange. The bank can buy at the market selling rate and sell at the
market buying rate.
4. Forward Contract Cancellation Rules
a. The customer is having the right to cancel a forward contract at any time during the
currency of the contract. The cancellation is governed by Rule 8 of the FEDAI.
b. The difference between the contracted rate and the rate at which the cancellation is done
shall be recovered or paid to the customer, if the cancellation is at the request of the
customer. Exchange difference not exceeding Rs.50 shall be ignored.
c. The spot rate is to be applied for cancellation of the forward contract on due date. The
forward rate is to be applied for cancellation before due date. In the absence of any
instruction from the customer, contracts which have matured shall on the 15th day from
the date of maturity be automatically cancelled. If the 15th day falls on a holiday or
Saturday the cancellation will be done on the next succeeding working day.
d. The customer is liable for recovery of cancellation charges and in no case the gain is
passed on to the customer since the cancellation is done on account of customer’s default.
e. The customer may approach the bank for cancellation when the underlying transaction
becomes infractions, or for any other reason he wishes not to execute the forward
contract.
f. If the underlying transaction is likely to take place on a day subsequent to the maturity of
the forward contract already booked, he may seek extension in the due date of the
contract.

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g. Such requests for cancellations or extension can be made by the customer on or before the
maturity of the forward contract.
5. Cancellation of Forward Contract on Due date
a. When a forward purchase contract is cancelled on the due date it is taken that the bank
purchases at the rate originally agreed and sells the same back to the customer at the
ready TT rate.
b. The difference between these two rates is recovered from/paid to the customer. If the
purchase rate under the original forward contract is higher than the ready T.T selling rate
the difference is payable to the customer.
c. If it is lower, the difference is recoverable from the customer. The amounts involved in
purchase and sale of foreign currency are not passed through the customer’s account.
Only the difference is recovered/paid by way of debit/credit to the customer’s account.
d. In the same way when a forward sale contract is cancelled it is treated as if the bank sells
at the rate originally agreed and buys back at the ready T.T buying rate. The difference
between these two rates is recovered from/paid to the customer.
6. Early Cancellation of a Forward Contract:
a. Sometimes the request for cancellation of a forward purchase contract may come from a
customer before the due date. When such requests come from the customer, it would be
cancelled at the forward selling rate prevailing on the date of cancellation, the due date of
this sale contract to synchronize with the due date of the original forward purchase
contract.
b. On the other hand if a forward sale contract is cancelled earlier than the due date,
cancellation would be done at the forward purchase rate prevailing on that day with due
date of the original forward sale contract
7. Extension on Due date
a. An exporter finds that he is not able to export on the due date but expects to do so in
about two months. An importer is unable to pay on the due date but is confident of
making payment a month later. In both these cases they may approach their bank with
whom they have entered into forward contracts to postpone the due date of the contract.
Such postponement of the date of delivery under a forward contract is known as the
extension of forward contract.
b. The earlier practice was to extend the contract at the original rate quoted to the customer
and recover from him charges for extension. The reserve bank has directed that, with
effect from16.1.95 when a forward contract is sought to be extended, it shall be cancelled
and rebooked for the new delivery period at the prevailing exchange rates.
c. FEDAI has clarified that it would not be necessary to load exchange margins when both
the cancellation and re-booking of forwards contracts are undertaken simultaneously.
However it is observed that banks do include margin for cancellation and rebooking as in
any other case. Further only a flat charge of Rs.100 (minimum) should be recovered and
not Rs.250 as in the case of booking a new contract.
8. Overdue Forward Contracts
a. In the absence of any instructions from the customer, contracts which have matured shall
on the 15th day from the date of maturity be automatically cancelled.
b. The customer cannot effect delivery extend or cancel the contract after the maturity date
and the procedure for automatic cancellation on the 15th day from maturity date should
be adhered to in all cases of default by the customer.
c. Charges on cancellation: Cancellation charges shall be payable consisting of following:

7
i. Exchange Difference: The difference between Spot Rate of offsetting position

(cancellation rate) on the date of cancellation of contract after due date or 15 days
(whichever is earlier) and original rate contracted for.
ii. Swap Loss: The loss arises on account of offsetting its position created by early
delivery as bank normally covers itself against the position taken in the original
forward contract. This position is taken at the spot rate on the date of cancellation
earliest forward rate of offsetting position.
iii. Interest on Outlay of Funds: Interest on the difference between the rate entered by
the bank in the interbank market and actual spot rate on the due date of contract
of the opposite position multiplied by the amount of foreign currency amount
involved. This interest shall be calculated for the period from the due date of
maturity of the contract and the actual date of cancellation of the contract or 15
days whichever is later.
d. Please note in above in any case there is profit by the bank on any course of action same
shall not be passed on the customer as normally passed cancellation and extension on or
before due dates
9. Roll over Forward Contracts
a. When deferred payment transactions of imports/exports takes place, the repayment of the
installment and interests on foreign currency loans by the customer requires long term
forward cover where the period extends beyond six months.
b. The bank may enter into forward contract for long terms provided there is suitable cover
is available in the market. However the cover is made available on roll over basis in
which cases the initial contract may be made for a period of six months and subsequently
each deferred installments for the outstanding balance of forward contract by extending
for further periods of six months each.
c. For these transactions the rules and charges for cancellation / extension of long term
forward contracts are similar to those of other forward contracts.
10. Swap Deals:
a. Swap contracts can be arranged across currencies. Such contracts are known as currency
swaps and can help manage both interest rate and exchange rate risk. Many financial
institutions count the arranging of swaps, both domestic and foreign currency, as an
important line of business. This method is virtually cheaper than covering by way of
forward options. Technically, a currency swap is an exchange of debt service obligations
denominated in one currency for the service in an agreed upon principal amount of debt
denominated in another currency. By swapping their future cash flow obligations, the
counterparties are able to replace cash flows denominated in one currency with cash
flows in a more desired currency.
b. A ‘swap deal’ is a transaction in which the bank buys and sells the specified foreign
currency simultaneously for different maturities. Thus a swap deal may involve:
i. Simultaneous purchase of spot and sale of forward or vice verse ; or
ii. Simultaneous purchase and sale, both forward but for different maturities. For
instance, the bank may buy one month forward and sell two months forward.
Such a deal is known as ‘forward swap’.
c. A swap deal should fulfill the following conditions:
i. There should be simultaneous buying and selling of the same foreign currency of
same value for different maturities; and The deal should have been concluded
with the distinct understanding between the banks that it is a swap deal.

7
ii. A swap deal is done in the market at a difference from the ordinary deals. In the
ordinary deals the following factors enter into the rates:
d. The difference between the buying and selling rates; and The forward margin, i.e.,the
premium or discount.
e. In a swap deal the first factor is ignored and both buying and selling are done at the same
rate. Only the forward margin enters into the deal as the swap difference.
f. In a swap deal, both purchase and sale are done with the same bank and they constitute
two legs of the same contract. In a swap deal, it does not really matter as to what is spot
rate. What is important is the swap difference which determines the quantum of net
receipt of payment for the bank as a result of the combined deal. But the spot rate decides
the total value in rupees that either of the banks has to deploy till receipt of forward
proceeds on the due date. Therefore, it is expected that the spot rate is the spot rate ruling
in the market. Normally, the buying or selling rate is taken depending upon whether the
spot side is respectively a sale or purchase to the market-maker. The practice is also to
take the average of the buying and selling rates. However, it is of little consequence
whether the purchase or selling or middle rate is taken as the spot rate.
g. Need for Swap Deals:
i. Some of the cases where swap deal may become necessary are described below:
ii. When the bank enters into a forward deal for a large amount with the customer
and cannot find a suitable forward cover deal in the market, recourse to swap deal
may become necessary.
iii. Swap may be needed when early delivery or extension of forward contracts is
effected at the request of the customers.Please see chapter on Execution of
Forward Contracts and Extension of Forward Contract.
iv. Swap may be carried out to adjust cash position in a currency. This explained
later in the chapter on Exchange Dealings.
v. Swap may also be carried out when the bank is overbought for certain maturities
and oversold for certain other maturities in a currency.
h. Swap and Deposit/Investment:
i. Let us suppose that the bank sells USD 10,000 three months forward, Instead of covering
its position by a forward purchase, the bank may buy from the market spot dollar and kept
the amount in deposit with a bank in New York. The deposit will be for a period of three
months. On maturity, the deposit will be utilized to meet its forward sale commitment.
Such a transaction is known as ‘swap and deposit’. The bank may resort to this method if
the interest rate at New York is sufficiently higher than that prevailing in the local market.
If instead of keeping the amount in deposit with a New York bank, in the above case, the
spot dollar purchased is invested in some other securities the transaction is known as
‘swap and investment’.
11. Summary of forward contract disposal
a. Cancellation on due date: Difference between agreed forward rate and spot rate shall be
paid to /received from customer .
b. Cancellation earlier to due date: Difference between agreed forward rate and forward rate
on cancellation shall be paid to /received from customer. But amount will be settled on
due date only not on date of cancellation.
c. Early Delivery: If customer requests for early execution of forward contract, bank should
oblige at the forward rate agreed earlier. Impact of such transaction whether gain or loss
shall be settled with customer.
i. Swap loss/gain = Spot rate on early delivery – forward rate on early deliver.

7
ii. Interest on outlay = Interest on difference between forward rate agreed earlier and
spot rate on early delivery.
d. Over Due Contracts
e. Effective date of cancellation : Date of cancellation or 15 days from due date , Which
ever is earlier
f. Transactions by Bank
i. On Due Date: Swap spot sell and forward buy 1 month
ii. On Cancellation date
iii. Collect charges from customer
1. Swap cost : Difference between agreed forward rate and forward rate on
due date
2. Exchange difference: Difference between agreed forward rate and spot
rate on date of cancellation. In case, the contract is ultimately cancelled,
the customer will not be entitled to the exchange difference, if any, in his
favour, since the contract is cancelled on account of his default.
3. Interest on outlay of funds: Interest on difference between cover rate and
spot rate on due date
iv. In case of delivery subsequent to automatic cancellation the appropriate current
rate prevailing on such delivery date shall be applied.

7
8.8 Currency options

1. Meaning:
a. Currency option contracts are agreements where one party will have the right and other
will have the obligation on underlying asset which is currency.
b. Under currency options both underlying asset and medium of measurement will be
currencies.
2. Type of option i,e call or put to be decided based on movement of Underlying Asset
a. If underlying asset is purchased, then it is call option
b. If underlying asset is sold, then it is put option
3. Strike price and option premium will be in same units of currency.
a. If U/A is for every $ then Premium also will be for every $
b. If U/A is for every Rs then Premium also will be for every Rs
4. Every call option on underlying asset is implied put option on other currency. Example a call
option on USD is implied put option on Rs
a. When Underlying Asset is “Received “ (purchase) it is call option
b. When Underlying Asset is “Given “ (Sold) it is put option
5. Hedging using options
a. At the time of hedging from exporter or importer point of view transaction in currency
market to be considered w.r.t underlying asset to choose call option or put option.
b. Example,
i. An importer is UK
ii. Transactions are
1. Purchase goods from USA
2. To Make payment, Purchase USD from Bank(Currency market)
3. Make Payment to Supplier.
iii. For hedging purpose, Transaction 2 is relevant which is “Receiving USD”.
c. Options applicable
i. If underlying asset is USD, then option to be selected is “Call option on USD”
ii. If Underlying Asset is GBP, then option to be selected is “ Put option on GBP”
d. Cash flow under options will involve the following
i. Premium at the beginning
ii. Interest on premium for the term of option contract
iii. Strike Price or Market price at expiry
e. Why option hedging is not perfect hedging
i. Accurate cash flow amount under option can’t be computed at the beginning of
contract, since it is subject to market price at expiry. However it ensures
maximum outflow for importer(not beyond strike Price) and minimum inflow for
exporter(not below market Price). Hence to that extent cash flows are protected
from uncertainty which will achieve the purpose of hedging. Actual effectiveness
of hedging under option can be determined only on expiry .
ii. Since at the time of decision to choose between different hedging strategies
element of market price at expiry is not considered in options, there is a view that
interest on premium shouldn’t be considered in cash flow under option hedging.

7
8.9 Currency futures

1. Meaning
a. A currency future, also known as FX future, is a futures contract to exchange one
currency for another at a specified date in the future at a price (exchange rate) that is fixed
on the purchase date.
b. On NSE the price of a future contract is in terms of INR per unit of other currency e.g.
US Dollars. Currency future contracts allow investors to hedge against foreign exchange
risk.
c. Currency Derivatives are available on four currency pairs viz. US Dollars (USD), Euro
(EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). Currency options are
currently available on US Dollars.
2. Forwards and Futures – Difference

a. Trading: Forward contracts are traded on personal basis or on telephone or otherwise.
Futures contracts are traded in a competitive arena.
b. Size of contract: Forward contracts are individually tailored and have no standardised
size. Futures contracts are standardised in terms of quantity or amount as the case may be.
c. Organised exchanges: Forward contracts are traded in an over the counter market. Futures
contracts are traded on organised exchanges with a designated physical location.
d. Settlement: Forward contracts settlement takes place on the date agreed upon between
the parties. Futures contracts settlements are made daily via exchange’s clearing house.
e. Delivery date: Forward contracts may be delivered on the dates agreed upon and in terms
of actual delivery. Futures contracts delivery dates are fixed on cyclical basis and hardly
takes place. However, it does not mean that there is no actual delivery.
f. Transaction costs: Cost of forward contracts is based on bid – ask spread. Futures
contracts entail brokerage fees for buy and sell orders.
3. Application
a. Currency futures are agreements entered today for a settlement at later date and at a price
which is fixed today. Under currency futures, underlying asset will be various currencies.
b. Forward buy on underlying asset is a implicit forward sell on another currency and vice
versa.
c. Other features of futures remain same
i. Lot size
ii. Settlement only on net (Square off)
iii. MTM settlement
iv. Initial Margin
4. Example,
a. Underlying Asset is $.
b. Mr.A enters into future buy at Rs.60 with Mr.B .
c. On date of expiry $ are trading at 61.
d. Implications
e. For A :
i. will receive 1 Re for every $ because of square off
ii. Earlier future buy @60, later future sell@61
f. For B

7
i. will Pay Re 1 for every $ because of square off

ii. Earlier Future sell@60,later future buy @61
5. Currency future as hedging tool

a. To hedge using currency futures contract is entered based on risk of the person.
b. Future Buy or Future sell depends on the position of exporter/importer w.r.t underlying
asset in currency market.
c. For importer
i. An importer carries the risk of raising currency rates, hence will enter into future
buy contract today and will square off during settlement by future sell.
ii. In this situation if the expectation of raising rates came true, then profit would
realised in future market which will compensate for the loss in spot market.
iii. If rates reduced, then there will be loss in future market which will be
compensated by profit in spot market.
d. For exporter
i. And similarly, an exporter will enter into future sell today and later square off at
expiry by future buy.
ii. Currency futures can’t be used as tool of perfect hedging since 100% cash flow
can’t be estimated at the time of entering to contract.
iii. However, it does cover the loss in either markets, actual amount of coverage will
be known only during settlement.
e. If any fractional no. of contracts is obtained, no coverage is done for such fractional
amount. Since currency future anyway cant cover perfect hedging. Hence fractional
amount is kept as unhedged position
f. Steps in hedging
i. Identify Type of contract
1. In general, an exporter will enter into future sell and importer enter into
future buy .
2. But during indirect quote ( Currency of underlying asset is same as
currency of country to which the person belong) future transactions will
be opposite. i.e importer will enter into future sell and exporter will enter
into future buy.
ii. Transactions
1. Enter into future Buy or Sell at current future price
2. Initial margin depending on number of contracts (Not to be considered
for overall cash flow since it will be refunded)
3. If number of contracts are in fractions, no position required for fractions
portion.
iii. At expiry
1. Square off in future market (opposite of what is done earlier)
2. Settlement of foreign currency in spot market
3. Pay Interest on Initial margin
4. Note: When indirect quote is given, one extra step will apply for
conversion of settlement amount during square off using spot rate at the
time of square off.
g. How Hedging is effective in Currency Futures
i. Currency futures can’t be used as tool of perfect hedging since 100% cash flow
cant be estimated at the time of entering to contract.

7
ii. However, it does cover the loss in either markets, actual amount of coverage will
be know only during settlement.

7
8.10 Nostro, Vostro and Loro

1. Introduction
a. Nowadays, bank operations are not confined within a national border. Banks are opening
branches in foreign countries. But the problem is - Is it possible for a bank to open branch
in each and every country? Obvious answer is no.
b. Then what is the easiest way to handle this situation? Open an account in the foreign
countries' bank! Here Nostro, Vostro and Loro accounts come into play. Note that all
these accounts are termed as one's own country-basis.
2. NOSTRO Account
a. Italian word 'nostro' means 'ours'. Hence, Nostro account points at - "Our account with
you". Nostro accounts are generally held in a foreign country (with a foreign bank), by a
domestic bank (from our perspective, our bank). It obviates that account is maintained in
that foreign currency.
b. For example, SBI account with HSBC in U.K. (may be). Another example, an Indian
bank authorized to deal in foreign exchange maintain an account with overseas bank in
USA in US Dollar such account maintained in the foreign currency at foreign center by
Indian bank is said as ‘Nostro Account’ .
3. VOSTRO Account
a. Italian word 'vostro' means 'yours'. Hence, Vostro account points at - "Your account with
us". Vostro accounts are generally held by a foreign bank in our country (with a domestic
bank). It generally maintained in Indian Rupee (if we consider India)
b. For example, HSBC account is held with SBI in India. (may be).Another example, XYZ
bank of USA maintains an account with a Bank in India in Indian Rupee such account
maintained in the foreign currency at foreign center by Foreign bank is said as ‘Vostro
Account’
4. LORO Account
a. Again, Italian word 'loro' means 'theirs'. Therefore, it points at - "Their account with
them". Loro accounts are generally held by a 3rd party bank, other than the account
maintaining bank or with whom account is maintained.
b. For example, BOI wants to transact with HSBC, but doesn't have any account, while SBI
maintains an account with HSBC in U.K. Then BOI could use SBI account. (again may
be)
c. The terms Nostro (Our) and Vostro (Your) are used in the bilateral correspondence
between the concerned two Banks ie the Bank maintaining the account and the Bank in
whose book the account is maintained. But in such correspondence when third bank
account is referred it is said as LORO account. For example when XYZ bank of India is
maintaining an account with ABC Bank in New York USA in USD when PQR bank of
India refers the said account in correspondence with XZY Bank, Now YORK it is said
LORO account
5. Exchange Position
a. It is referred to total of purchases or sale of commitment of a bank to purchase or sale
foreign exchange whether actual delivery has taken place or not.
b. In other words all transactions for which bank has agreed with counter party are entered
into exchange position on the date of the contract.

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8.11 Summary chart
1 Unit of FC=
Direct
…Units of LC
Quote
1 Unit of LC
Indirect
=….Units of FC
Bid rate Bank buy
Spread
Offer rate Bank sell
Bank
Players Customer
Terms
Interbank
For Customer With
bank
Position Disadvantage
For Bank With
interbank
Bid – Margin
Between bank and
customer
Offer+Margin
Margin
Inter bank market No Margin

7
Transactions today Spot
Spot or Forward
Transactions later Forward rate
IF LHS currency
Multiply
mentioned
Foreign exchange
Multiply or Divide
conversion rates
If RHS currency
Divide
mentioned
If purchased
Higher rate
(receive)
Higher or lower
If sold(pay) Lower rate
How many units of USD to be sold to get GBP 1000

(1 GBP= 1.34 USD )
•LHS GBP
•RHS USD
•Given 1000 GBP (LHS)
•Multiply
How many Rs to be sold to get 1000 USD

( 1 Re = 0.025 USD)
• LHS INR
• RHS USD
• Given 10000 USD(RHS)
• Divide

7
Cross rates
Cross rates
Meaning Objective Process
Rate arrived When spread When spread

Necessity
at using not given given
intermediate
currency
Express
Opportunity mathematical For Buy For sell
ly
𝐴 𝐴 𝐵
Keep the Start with
= x
𝐶 𝐵 𝐶
objective in currency you
the end have
Previous Next
transactions transactions
in terms of in terms of
buy sale

7
Forward rates
Rate agreed today
Meaning
For settlement later date
when FR>spot
At premium
rate
When FR<Spot
Basics Trading At Discount
rate
% F-S*100*12
premium/discount S m
Importer Forward Buy

Position
Exporter Forward Sale
From right
Consider
to left
When
Swap points Add
increasing
When
Subtract
decreasing
Quotation Apply on Other side
Multiply
100+ to
LHS RHS
Appreciatio
Movement n RHS
depreciates
Multiply
100- to RHS
LHS
depreciation
RHS
appreciates

7
Purchasing power parity
Purchasing
power parity
theorem
Meaning Spot rate Forward rate Computation
Implied rate
Implied rate FR = Spot(1+Local
based on
Law of one based on inflation)
ability to
price inflation of
purchase same (1+foreign inflation)
two currencies
product
Currency may If Actual FR

Currency with
be different, is different,
lower inflation
purchasing there exists
will be trading
power should arbitrage
at premium
be same opportunity
Interest rate parity theory
Two currencies are

indifferent
Meaning
for borrowing and
investing
Savings in money
market(interest) =
If borrowing is cheaper
Loss in currency market(
conversion rate)
Impact
Interest rate parity
Loss in money
market(interest)
If borrowing is costlier
theorem
= Gain in currency
Implied rate based on market(conversion rate)
interest rates of two
Forward rate currencies One currency is good for
If Actual FR is different borrowing
arbitrage opportunity Another currency is good
for investing
FR = Spot(1+Local interest)
(1+foreign interest)
Computation
If Actual FR is different, there

exists arbitrage opportunity

7
Arbitrage in IRPT
Actual FR> Actual FR<

theoretical FR theoretical FR
Implies Transactions today Implies Transactions today
Enter into forward Enter into forward

FR is overpriced FR is under priced
sell FC buy FC
Overpriced= sell Spot buy FC Overpriced= buy Spot sell FC
Borrow LC Borrow FC
Deposit FC Deposit LC

7
Steps in Arbitrage Using currency market
If forward foreign currency is over priced,
Today Later
Buy Spot Buy FC -
sell Forward sell FC Sell FC using forward contract
Borrow Borrow LC Repay LC Borrowings
Deposit Deposit FC Deposit FC Matures
If forward foreign currency is under priced

Today Later
Buy Spot Sell FC -
Buy FC using forward
Sell Forward buy FC contract
Borrow Borrow FC Repay FC Borrowings
Deposit Deposit LC Deposit LC Mature
• Fundamental Rule
o Borrow and deposit should happen in different currencies
o Spot buy means forward sell and vice versa

7
Foreign currency exposure hedging
Reduce or avoid conversion rate risk
Meaning
Make CF certain to the extent possible

Foreign currency exposure hedging
Enter into forward

Forward hedging
contract
Use Deposit and

Money market hedging
borrowing
Set off of payables and

Netting
receivables
Leading Advance payment
Types
Lagging Delay payment
Options Currency options
Futures Currency futures
Swaps Currency swap

7
Money Market Hedging (Being an Exporter)
Shortcut
• Exporter
• Invoice amount Spot rate(Sell)(2) * (1+local Deposit ) (3)
(1+Foreign borrowing) (1)
• Step 1 : Borrow in Foreign currency = Invoice Amount
• (1+Foreign borrowing)
• Step 2 : Sell the foreign currency above in Spot rate and deposit in Local currency
• Step 3 : Deposit in step 2 above will mature along with interest
= Deposit(1+local Deposit )

7
Money Market Hedging (Being an importer)
Shortcut
• Importer
• Invoice amount Spot rate(buy)(2) * (1+local Borrowing ) (3)
(1+Foreign Deposit) (1)
• Step 1 : Deposit in Foreign currency = Invoice Amount
• (1+Foreign Deposit)
• Step 2 : Buy the foreign currency above in Spot rate and Borrow in Local currency
• Step 3 : Borrow in step 2 above will mature along with interest
= Borrow(1+local Borrow )

7
Supplier credit Vs Bank Credit
Type Supplier credit Bank Credit
Interest rate Foreign interest rate Local interest rate
Rate for conversion Forward rate Spot rate
Interest first , later Conversion first later

Sequence
conversion interest
Steps in making decision on Supplier credit Vs Bank Credit.
1. Cash flow under Supplier credit

b. Add Interest charged by supplier for credit period
c. Total amount payable in Foreign currency = (a+b)
d. Total amount payable in local currency = (c) * Forward exchange rate
2. Cash flow under Bank Credit
b. Amount payable in local currency (a) * Spot exchange rate
c. Add interest charged by banker for credit period
d. Total amount payable in local currency = (b) + (c)

7
Using LOC, Letter of credit
Foreign currency
Type Local Currency Loan
Loan+LOC
Interest rate Foreign interest rate Local interest rate
Rate for conversion Forward rate Spot rate
Interest first , later Conversion first later

Sequence
conversion interest
Loc Commission*Spot
NA
buy rate
Loc
Local currency interest

NA
on above

7
Forward contract disposal
Execute
On Due Date Cancel = Opposite sopt
Extend =cancel+new
At original rate
Execute Swap differential

Forward contract
Interest on outlay
Before due date
Cancel Opposite forward
Extend Cancel +new
Execute = New spot
Swap diff
After due date Cancel= + exch diff
+ interest on outlay
Extend Cancel+new

7
Cancellation on due date

From
Customer
Point of view
Charges
Parties
paid/recd :
Exchange
difference Importer Exporter
=
Original On On
Forward Original : cancellatio Original : Cancellatio
Rate n: n:
Forward Spot Sell Forward Spot Buy

-
Buy rate rate Sell rate rate
Opposite
Spot rate
Cancellation Before due date

From
Customer
Point of view
Charges
paid/recd Parties
:
Exchange
difference Importer Exporter
=
Original On On
Forward Original : cancellati Original : Cancellati
Rate on : on :
Forward Forward Forward Forward

-
Buy rate Sell rate Sell rate Buy rate
Opposite
Forward
rate

7
Early settlement (Transaction by Bank)
To honor early
In Spot Market : settlement with
customer
On Early Settlement
Swap differential
date
To adjust cover rate
In Forward Market which will happen on
due date
Original Forward
CF1 :
rate with customer
Between the early
settlement date and Interest on outlay
due date
Spot rate on early
CF2
settlement date
Any profit in Passed on to

duecourse customer

7
Spot rate-
Swap loss/gain Forward rate for
remaining period
Charges
paid/recd :
Original forward
rate – Spot rate
Interest on outlay
on
For remaining
time period
Forward sell rate
From Bank point for remaining
of view Swap difference
period – Spot buy
rate
Importer
Original forward
Interest on outlay
sell rate- Spot
on
buy rate
Parties
Spot sell rate –
forward buy rate
Swap difference
for remaining
period
Exporter
Spot sell rate –

Interest on outlay
Original forward
on
buy rate

7
Overdue contracts(compulsory cancellation)
In Forward Original
market forward rate
On
Exchange
Cancellation
Difference
date
In Spot Opposite spot
Market sale
In Spot To Adjust
Market : cover rate
Swap
On Due Date
differential
To be ready if
In Forward
customer
Market
comes
CF1 : Cover rate

Between due
date and Interest on
cancellation outlay
date Spot rate to
CF2 adjust cover
rate
Any profit in Not Passed on
due course to customer

7
Currency option
Currency
option
Special
Meaning Features Type
features
Call option Put option

Option Option
Right to buy Right to sell on Foreign on foreign
contract premium
currency currency
Where Holder Call option Put option = Implicit = Implicit

underlying put option call option
asset is on local on local
currency currency currency
Writer
Strike price
Expiry date
\
Quotation 1 Unit=…Units
LHS in quotation
Step 1 : Identify Underlying Asset
is Underlying
Type of option
If underlying
Call option
purchased
Required
If underlying sold Put option
Option hedging(holder)
If U/A and Invoice

invoice are same amount/lot size
Step 2 : No of
contracts If U/A and Invoice amount/Strike Price
invoice are
difference Lot size
No of contracts*lot
Forward rate for
At expiry size*Strike Price(or
fraction
MP if not exercised)
Step 3: Cash If premium is FC,
flows calculations No of contracts*lot
At inception convert at Spot
size*Premium
buy
Interest on May be
premium considered

7
Currency futures
Future contract
Meaning
Underlying asset is
currency
Lot size
Margin
Currency futures
Expiry date
Features
Net settlement
Square off
MTM settlement
Future buy on FC = Future sell on LC
Special features
Future sell on FC = Future buy on LC

7
Quotation 1 Unit=…Units
LHS in
Underlying
quotation is
Step 1 : Asset
Underlying
Identify Type
of future
If underlying
Future buy
purchased
Required
If underlying
Future sell
sold
Invoice amount
No of contracts
Future hedging lot size *future rate
Step 2: At
inception
= No fo
contracts*
Initial Margin
Margin per
contract
Invoice*Spot
In Spot
rate
(FS-FB)*lot
Step 3: Cash In Future If FC, then
size*no of
flows at expiry square off convert at spot
contracts
Interest on
In Money
Margin

7
Nostro, Vostro and Loro
Our account with

you
Nostro
SBI having A/c with

Example
Citibank US
Your account with us
Foreign exchange
Vostro
accounts
Citibank US having
Example
A/c with SBI
Their account with

them
LORO
SBI having account

Example in Citibank through
HSBC

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8.12 Problems
Problem No 1. Conversion rates MTP May 2012
The following spot rates are observed in the foreign currency market.
Currency Foreign currency per U.S.$
Britain pound 00.62

Netherlands Guilder 1.90
Sweden Kroner 6.40
Switzerland Franc 1.50
Italy Lira 1,300.00
Japan Yen 140.00
On the basis of this information, compute to the nearest second decimal the number of :
(i) British pounds than can be acquired for $100.
(ii) Dollars that 50 Dutch guilders (a European Monetary Union legacy currency) will buy.
(iii) Swedish krona that can be acquired for $40.
(iv) Dollars that 200 Swiss francs can buy.
(v) Italian lira (an EMU legacy currency) that can be acquired for $10.
(vi) Dollars that 1,000 Japanese yen will buy
Problem No 2. Identifying appropriate rate for transaction
Rate Requirement Multiply or Higher or Rate

divide lower
1 USD = 50.12-50.25 Rs Purchase 1000 USD
1 GBP = 1.45-1.75 USD Purchase 1000 USD
1 USD = 50.12-50.25 Rs Sell 1000 USD
1 GBP = 1.45-1.75 USD Purchase 1000 GBP
1 GBP = 0.9025-0.9045 Sell 1000 EURO
EURO
1 AUD = 1.80-1.85 SGD Buy 1000 SGD
1 USD = 0.5075 - 0.6025 Sell 1000 GBP
GBP
1 EURO = 1.45-1.75 USD Sell 1000 EURO
1 GBP = 1.45-1.75 USD Sell 1000 USD
1 AUD = 0.9025 -0.9045 Buy AUD
GBP
Problem No 3. Cross rate delay in delivery

November 2011(5Marks),May 2014(8Marks), RTP May 2017,RTP November 2018,RTP
November 2019
On January 28, 2005 an importer customer requested a bank to remit Singapore Dollar (SGD)
25,00,000 under an irrevocable LC. However, due to bank strikes, the bank could effect the
remittance only on February 4, 2005. The interbank market rates were as follows:
Currency January, 28 February 4
Bombay US$1 = Rs. 45.85/45.90 45.91/45.97

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London Pound 1 = US$ 1.7840/1.7850 1.7765/1.7775

Pound 1 = SGD 3.1575/3.1590 3.1380/3.1390
The bank wishes to retain an exchange margin of 0.125%.
How much does the customer stand to gain or lose due to the delay? (Calculate rate in multiples of
.0001)
(Answer Hint : 2,28,250 (Loss) )
Problem No 4. Cross rate with alternative

November 2013(5 Marks), MTP May 2015,RTP May 2020, MTP May 2020
You, a foreign exchange dealer of your bank, are informed that your bank has sold a T.T. on
Copenhagen for Danish Kroner 10,00,000 at the rate of Danish Kroner 1 = Rs 6.5150.
You are required to cover the transaction either in London or New York market. The rates on that date
are as under:
• Mumbai-London Rs 74.3000 Rs74.3200
• Mumbai-New York Rs 49.2500 Rs 49.2625
• London-Copenhagen DKK 11.4200 DKK 11.4350
• New York-Copenhagen DKK 07.5670 DKK 07.5840
In which market will you cover the transaction, London or New York, and what will be the exchange
profit or loss on the transaction? Ignore brokerages.
(Answer Hint : The transaction would be covered through London which gets the maximum profit of
Rs 7,119)
Problem No 5. Finding forward premium with swap points
Given the following date

• Spot rate 45.01 – 45.12
• 3month Swap points 24/36
Find forward rates and premium/discount %
(Answer Hint : 2.13%, 3.19%)
Problem No 6. Forward premium with transaction exposure RTP November 2019
Excel Exporters are holding an Export bill in United States Dollar (USD) 1,00,000 due 60 days hence.
They are worried about the falling USD value which is currently at Rs 45.60 per USD. The concerned
Export Consignment has been priced on an Exchange rate of Rs 45.50 per USD. The Firm’s Bankers
have quoted a 60-day forward rate of Rs 45.20.
Calculate:
(i) Rate of discount quoted by the Bank
(ii) The probable loss of operating profit if the forward sale is agreed.
(Answer Hint : 5.33%, ₹30,000)
Problem No 7. Finding forward premium with interpolation

November 2016(5 Marks), MTP May 2019
On April 3, 2016, a Bank quotes the following:

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Particular Rates Rates

Spot exchange Rate (US $ 1) INR 66.2525 INR 67.5945
2 months’ swap points 70 90
3 months’ swap points 160 186
In a spot transaction, delivery is made after two days.

Assume spot date as April 5, 2016.
Assume 1 swap point = 0.0001,

(i) Ascertain swap points for 2 months and 15 days. (For June 20, 2016),
(ii) Determine foreign exchange rate for June 20, 2016, and
(iii) Compute the annual rate of premium/discount of US$ on INR, on an average rate.
(Answer Hint :(i) Swap Points for 2 months and 15 days 115,138 (ii) Foreign Exchange Rates for 20th
June 2016 66.2640, 67.6083, Annual Rate of Premium 0.0833%, 0.0980% )
Problem No 8. PPPT using inflation May 2010(4 Marks)
The rate of inflation in India is 8% per annum and in the U.S.A. it is 4%. The current spot rate for
USD in India is Rs 46. What will be the expected rate after 1 year to 4 years applying the Purchasing
Power Parity Theory.
(Answer Hint : 47.84, 49.75, 51.74, 53.81)
Problem No 9. Arbitrage in Forward market
Data below relates to foreign exchange rates between INR and USD
• Spot 1$ = Rs.50
• 6 months forward 1$ = Rs.56
• Indian interest rate 10%. US interest rate 5%.
Check if IRPT exists if not construct arbitrage strategy
(Answer Hint : Surplus 57.4 – 52.5 = 4.9)
Problem No 10. Money market hedging and forward hedging

November 2008(6 Marks),RTP May 2019, MTP November 2015, MTP November 2017
An exporter is a UK based company. Invoice amount is $3,50,000. Credit period is three months.
Exchange rates in London are : Spot Rate ($/£) 1.5865 – 1.5905, 3-month Forward Rate ($/£) 1.6100
– 1.6140
Rates of interest in Money Market :
Currency Deposit Loan

$ 7% 9%
£ 5% 8%
Compute and show how a money market hedge can be put in place. Compare and contrast the
outcome with a forward contract.
(Answer Hint : 217904 from MMH, 216852 from Forward )

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Problem No 11. Supplier Credit Vs Bank credit

November 2014(8 Marks), MTP November 2016, MTP May 2020
Gibralater Limited has imported 5000 bottles of shampoo at landed cost in Mumbai, of US $ 20 each.
The company has the choice for paying for the goods immediately or in 3 months time. It has a clean
overdraft limited where 14% p.a. rate of interest is charged.
Calculate which of the following method would be cheaper to Gibralter Limited.
(iv) Pay in 3 months time with interest @ 10% and cover risk forward for 3 months.
(v) Settle now at a current spot rate and pay interest of the overdraft for 3 months.
The rates are as follow :

• Mumbai Rs /$ spot : 60.25-60.55
• 3 months swap : 35/25
(Answer Hint : Option – I Rs 61,80,750, Option -II Rs 62,66,925 )
Problem No 12. Foreign currency options hedging
A Ltd. of India has imported some chemical worth of USD 3,60,000 from one of the U.S. suppliers.
The amount is payable in six months’ time. The relevant spot and forward rates are:
Spot rate 1USD =Rs68.10-68.20

6 months’ forward rate 1 USD =Rs69.82 –69.95
The borrowing rates in India and U.S. are 9% and 6% respectively and the deposit rates are
7.5% and 4.5% respectively.
Currency options are available under which one option contract is for USD 1,000. The option
premium at strike price of Rs.70.05 is 5Rs(call option) and Rs 4(put option)
The company has 3 choices:

(i) Forward cover
(ii) Money market cover, and
(iii) Currency option
Which of the alternatives is preferable?
Problem No 13. Currency options hedging with probability

MTP November 2012, MTP May 2015, MTP May 2018
XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the following
information is available:
• Spot rate 1 £ = $ 2.00
• 180 days forward rate of £ as of today = $1.96
Interest rates are as follows:
Particulars. U.K US
180 days deposit rate 4.5% 5% (Not annualized)
180 days borrowing rate 5% 5.5% (Not annualized)

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A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of $ 0.04.
XYZ Ltd. has forecasted the spot rates 180 days hence as below:
Future rate Probability

$ 1.91 25%
$ 1.95 60%
$ 2.05 15%
Which of the following strategies would be most preferable to XYZ Ltd.?

(i) A forward contract;
(ii) A money market hedge;
(iii) An option contract;
(iv) No hedging.
Show calculations in each case.
(Answer Hint : (i) Forward hedging $ 588,000 (ii) Money market hedge $6,05,742 (iii) Option cover $
595,560 (iv) No Hedging $ 5,86,500)
Problem No 14. Currency futures hedging with indirect quote

RTP May 2014,RTP November 2016,RTP May 2019, , MTP November 2014
XYZ Ltd. is an export oriented business house based in Mumbai. The Company invoices in
customers’ currency. Its receipt of US $ 1,00,000 is due on September 1, 2009.
Market information as at June 1, 2009 is:
Exchange Rates Currency Futures

US $/Rs US $/Rs Contract size Rs4,72,000
Spot 0.02140 June 0.02126
1 Month Forward 0.02136 September 0.02118
3 Months Forward 0.02127
Month Initial Margin Interest Rates in India

June Rs10,000 7.50%
September Rs15,000 8.00%
On September 1, 2009 the spot rate US $Re. is 0.02133 and currency future rate is 0.02134.
Comment which of the following methods would be most advantageous for XYZ Ltd.
(i) Using forward contract
(ii) Using currency futures
(iii) Not hedging currency risks
(Answer Hint : (i) Forward Hedging Rs.47,01,457 (ii) Currency future hedging Rs. 47,20,637 (iii)
Rs 46,88,232 )
Problem No 15. Exchange position and nostro MTP November 2013, RTP May 2013
You as a dealer in foreign exchange have the following position in Swiss Francs on 31st October,
2004:

7
Particulars Swiss Francs

Balance in the Nostro A/c Credit 1,00,000
Opening Position Overbought 50,000
Purchased a bill on Zurich 80,000
Sold forward TT 60,000
Forward purchase contract cancelled 30,000
Remitted by TT 75,000
Draft on Zurich cancelled 30,000
What steps would you take, if you are required to maintain a credit Balance of Swiss Francs 30,000 in
the Nostro A/c and keep as overbought position on Swiss Francs 10,000?
(Answer Hint : The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account
to Sw. Fcs. 30,000.)
Problem No 16. Cancellation before due date and extension
Suppose you as a banker entered into a forward purchase contract for US$ 50,000 on 5th March with
an export customer for 3 months at the rate of Rs 59.6000. On the same day you also covered yourself
in the market at Rs 60.6025. However on 5th May your customer comes to you and requests extension
of the contract to 5thJuly. On this date (5th May) quotation for US$ in the market is as follows:
• Spot Rs 59.1300/1400 per US$
• Spot/ 5th June Rs 59.2300/2425 per US$
• Spot/ 5thJuly Rs 59.6300/6425 per US$
Assuming a margin 0.10% on buying and selling, determine the extension charges payable by the
customer and the new rate quoted to the customer. Round off rates to nearest multiple of 0.0025
(Answer Hint : Exchange difference Rs14875 Profit, New rate 59.5700)
Problem No 17. Early delivery MTP November 2018
On 1 October 2015 Mr. X an exporter enters into a forward contract with a BNP Bank to sell US$
1,00,000 on 31 December 2015 at Rs 65.40/$. However, due to the request of the importer, Mr. X
received amount on 28 November 2015. Mr. X requested the bank to the take delivery of the
remittance on 30 November 2015 i.e. before due date. The inter-banking rates on 28 November 2015
was as follows:
• Spot Rs 65.22/65.27
• One Month Premium 10/15
If bank agrees to take early delivery then what will be net inflow to Mr. X assuming that the
prevailing prime lending rate is 18%.
(Answer Hint : Net inflow to Mr.x =65,19,725)
Problem No 18. Over due contract May 2015(9 Marks),RTP May 2018
An importer booked a forward contract with his bank on 10th April for USD 2,00,000 due on 10th
June @ 64.4000. The bank covered its position in the market at 64.2800.
The exchange rates for dollar in the interbank market on 10th June and 20th June were:

7
Particulars 10th June 20th June

Spot USD 1= 63.8000/8200 63.6800/7200
Spot/June 63.9200/9500 63.8000/8500
July 64.0500/0900 63.9300/9900
August 64.3000/3500 64.1800/2500
September 64.6000/6600 64.4800/5600
Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer requested on 20th June
for extension of contract with due date on 10th August. Rates rounded to 4 decimal in multiples of
0.0025. On 10th June, Bank Swaps by selling spot and buying one month forward.
Calculate:
(i) Cancellation rate
(ii) Amount payable on $ 2,00,000
(iii) Swap loss
(iv) Interest on outlay of funds, if any
(v) New contract rate
(vi) Total Cost
(Answer Hint : (i) Cancellation Rate: 63.6175 (ii) Amount payable on $ 2,00,000 is Rs 1,56,740 (iii)
Swap Loss Rs 30,000 iv) Interest on Outlay of Funds Rs 320 (v) New Contract Rate 64.3150 (vi)
Total Cost Rs 1,87,060.00)
Problem No 19. Early delivery July 2021(O)(8 Marks)
On 1st October, 2020 Mr. Guru, an exporter, enters into a forward contract with the Bank to sell USD
1,00,000 on 31st December 2020 at INR/USD 75.40. However, at the request of the importer, Mr.
Guru received the amount on 30th November, 2020. Mr. Guru requested the bank take delivery of the
remittance on 30th November, 2020 i.e. before due date.
The inter-bank rate on 30th November 2020 was as follows:
Spot INR/USD 75.22-75.27
One Month Premium 10/15
Assume 365 days in a year.
(i) If bank agrees to take early delivery then what will be net inflow to Mr. Guru assuming that the
prevailing prime lending rate is 18% per annum.
(ii) If Mr. Guru can deploy these funds in USD, he gets return at the rate of 3% per annum. Which is
better ? Why ?

7
INTERNATIONAL FINANCIAL
MANAGEMENT
Marks distribution

7
9.1 Basics
1. Foreign investment
a. Meaning: Investment, which is made to serve the business interest of the investor in a
company, which is in a different national (host country) distinct from the investor’s
country of origin (home country).
b. Forms
i. Foreign Direct Investment (FDI) : Invest directly in share capital
ii. Foreign Portfolio Investment (FPIs) : Invest in capital market
c. Differences
FDI FPI
Investment in productive assets (whose value Investment in financial assets like
increase over time) like plant and machinery stocks, bonds, mutual funds, etc.
for a business
Investment gives investors ownership right as Investment gives investors only
well as management right ownership right and not
management right
Engage in decision making of a firm Not involved in decision making
Investors enter a country with long-term Investors can plan for long but often
approach have short-term plans
So investors cannot depart from the country Investors can easily depart from the
easily country
2. Instruments of International Finance
a. External Commercial Borrowings : obtained and utilized for specified purposes only
b. Euro Bonds: Denominated in a currency issued outside the country
c. Foreign Currency Options
d. Foreign Currency Futures
e. Foreign Currency Convertible Bonds
f. Depository receipts - Global- GDR , American- ADR ,Indian - IDR
3. American Depository Receipts (ADRs):
a. A depository receipt is basically a negotiable certificate denominated in US dollars
b. Represent a non- US Company’s publicly traded local currency (INR) equity
shares/securities
c. Receipts are issued outside the US, but issued for trading in the US they are called ADRs.
d. Flow of transactions
e. Indian company goes to custodian bank & deposits share certificates
f. Custodian bank makes arrangement with US bank
g. US bank issues ADR that are traded in stock exchanges of US
h. An American can invest in ADR and thereby own a share of indian company
4. Global Depository Receipt
a. It is an instrument in the form of a depository receipt or certificate created by the
Overseas Depository Bank outside India denominated in dollar and issued to non-resident
investors against the issue of ordinary shares
b. GDR is similar to ADR except that it can be traded throughout the world such as Europe ,
Africa etc
5. Indian Depository Receipts (IDRs)
a. Like ADRs and GDRs, foreign companies are now available for investments in India in
the form of IDRs.
b. Investment in these companies can be made by Indian investors.

7
9.2 Capital budgeting under foreign exchange transactions

1. Evaluation
a. NPV is the basis for all capital decision makings
b. Even under foreign currency projects NPV is the basis
c. NPV can be either calculated in indian rupee or foreign currency
d. If foreign currency NPV is calculated then discounting rate should be after considering
exchange fluctuation risk
(1+ discounting rate in foreign currency)*(1+ Risk free rate in india)
=(1+ required rate of return)
2. Risk Adjusted return of the project
a. Risk profile of two countries would be different for various reasons such as political
stability, availability of natural resources, economic development etc
b. Hence it is not appropriate to expected same rate of return in two countries even though
project is exactly same. i,e discounting rate when CF in Rs should be different from CF in
USD.
c. At the time of decision making whether to invest in project of foreign country or not
depends on NPV computed in foreign currency terms.
d. Such NPV is based on CF is foreign currency and discounted at a rate appropriate in
foreign country, which will be different from the rate if the same project is done in home
country.
e. This discounting rate applied on foreign currency cash flows after considering relevant
factors is called as exchange risk adjusted return of Project.
f. Exchange Risk adjusted return of project =
(1 + Interest rate in foreign) (1+required rate of return of project) - 1
(1+ Interest rate in Local)
9.3 International working capital management

1. Basics
a. Although the fundamental principles governing the managing of working capital such as
optimization and suitability are almost the same in both domestic and multinational
enterprises, the two differ in respect of the following:
i. MNCs, in managing their working capital, encounter with a number of risks
peculiar to sourcing and investing of funds, such as the exchange rate risk and the
political risk.
ii. Unlike domestic firms, MNCs have wider options of procuring funds for
satisfying their requirements or the requirements of their subsidiaries such as
financing of subsidiaries by the parent, borrowings from local sources including
banks and funds from Eurocurrency markets, etc.
iii. MNCs enjoy greater latitude than the domestic firms in regard to their capability
to move their funds between different subsidiaries, leading to fuller utilization of
the resources.
iv. Finance managers of MNCs face problems in taking financing decision because
of different taxation systems and tax rates

7
b. In sum, through MNCs have some advantages in terms of lattitude and options in
financing, the problems of working capital management in MNCs are more complicated
than those in domestic firms mainly because of additional risks in the form of the
currency exposure and political risks as also due to differential tax codes and taxation
rates
2. Issues in International working capital management
a. INTRA CORPORATE TRANSFER OF FUNDS
b. TRANSFER PRICING
c. MULTINATIONAL CASH MANAGEMENT
d. MULTINATIONAL RECEIVABLES MANAGEMENT
e. MULTINATIONAL INVENTORY MANAGEMENT
3. The techniques employed to optimize cash flows are:
a. Accelerating cash inflows,
b. Minimizing currency conversion costs,
c. Managing blocked funds and implementing inter-subsidiary cash transfers.
d. MNCs' efforts to optimize cash are compounded by company-related characteristics of
banking systems.

7
9.4 Summary chart
Exchange Risk adjusted return of project =

(1 + Interest rate in foreign) (1+required rate of return of project) -1
(1+ Interest rate in Local)
Computing NPV in foreign capital budgeting
Option 1: CF in INR Option 2: CF in Foreign currency
Determine exchange rates using

Use Foreign Cash flows
IRPT
Discount using Exchange Risk

Convert every year CF into INR
adjusted foreign currency
Discount using Required rate of

Result in NPV in foreign
return of project
Result is NPV in INR NPV*Spot rate= NPV in INR

7
9.5 Problems
Problem No 1. GDR RTP May 2021
Right Limited has proposed to expand its operations for which it requires funds of $ 30 million, net of
issue expenses which amount to 4% of the issue size. It proposed to raise the funds though a GDR
issue. It considers the following factors in pricing the issue:
(i) The expected domestic market price of the share is Rs 300 (Face Value of Rs 10 each share)
(ii) 4 shares underly each GDR
(iii) Underlying shares are priced at 20% discount to the market price
(iv) Expected exchange rate is Rs 70/$
You are required to compute the number of GDR's to be issued and cost of GDR to Right Limited, if
20% dividend is expected to be paid with a growth rate of 20%.
Problem No 2. MNC coming into India

May 2014(10 Marks),RTP November 2016,RTP May 2017,RTP May 2018,RTP November 2019,
MTP November 2018, MTP May 2020
A multinational company is planning to set up a subsidiary company in India (where hitherto it was
exporting) in view of growing demand for its product and competition from other MNCs. The initial
project cost (consisting of Plant and Machinery including installation) is estimated to be US$ 500
million. The net working capital requirements are estimated at US$ 50 million. The company follows
straight line method of depreciation. Presently, the company is exporting two million units every year
at a unit price of US$ 80, its variable cost per unit being US$ 40.
The Chief Financial Officer has estimated the following operating cost and other data in respect of
proposed project:
(i) Variable operating cost will be US $ 20 per unit of production;
(ii) Additional cash fixed cost will be US $ 30 million p.a. and project's share of allocated fixed cost
will be US $ 3 million p.a. based on principle of ability to share;
(iii) Production capacity of the proposed project in India will be 5 million units;
(iv) Expected useful life of the proposed plant is five years with no salvage value;
(v) Existing working capital investment for production & sale of two million units through exports
was US $ 15 million;
(vi) Export of the product in the coming year will decrease to 1.5 million units in case the company
does not open subsidiary company in India, in view of the presence of competing MNCs that are
in the process of setting up their subsidiaries in India;
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.
Assuming that there will be no variation in the exchange rate of two currencies and all profits will be
repatriated, as there will be no withholding tax, estimate NPV of the proposed project in India.
Present Value Interest Factors (PVIF) @ 12% for five years are as below:
Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674
(Answer Hint : NPV 103.0822 ($ Million))

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Problem No 3. Exchange Risk adjusted discounting rate
The risk free rate in US is 4% and the same in India is 8%. Required rate of return on this project is
10%.Compute risk adjusted dollar rate of required return.
Problem No 4. Indian company going outside India with PPPT

May 2013(10 Marks), MTP November 2014,RTP May 2015,RTP November 2015,RTP May
2018, MTP November 2018
XY Limited is engaged in large retail business in India. It is contemplating for expansion into a
country of Africa by acquiring a group of stores having the same line of operation as that of India.
The exchange rate for the currency of the proposed African country is extremely volatile. Rate of
inflation is presently 40% a year. Inflation in India is currently 10% a year.
Management of XY Limited expects these rates likely to continue for the foreseeable future.
Estimated projected cash flows, in real terms, in India as well as African country for the first three
years of the project are as follows:
Year – 0 Year – 1 Year – 2 Year - 3

Cashflowsin IndianRs (000) -50,000 -1,500 -2,000 -2,500
Cash flows in African Rands (000) -2,00,000 +50,000 +70,000 +90,000
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year indefinitely. It
evaluates all investments using nominal cash flows and a nominal discounting rate. The present
exchange rate is African Rand 6 to Rs 1.
You are required to calculate the net present value of the proposed investment considering the
following:
(i) African Rand cash flows are converted into rupees and discounted at a risk adjusted rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect it’s high risk.
(iii) Ignore taxation.
Year - 1 Year – 2 Year - 3

PVIF @ 20% .833 .694 .579
(Answer Hint : Total NPV of the Project = -59320 (Rs ‘000) + 48164 ( Rs ’000) = -11156 ( Rs ’000))
Problem No 5. Surplus fund management

November 2013(8 Marks), MTP November 2015, MTP May 2017,RTP November 2017,RTP
May 2018, RTP November 2021
Your bank’s London office has surplus funds to the extent of USD 5,00,000/- for a period of 3
months. The cost of the funds to the bank is 4% p.a. It proposes to invest these funds in London, New
York or Frankfurt and obtain the best yield, without any exchange risk to the bank. The following
rates of interest are available at the three centres for investment of domestic funds there at for a period
of 3 months.
• London 5 % p.a.

7
• New York 8% p.a.

• Frankfurt 3% p.a.
The market rates in London for US dollars and Euro are as under:
London on New York Rates

Spot 1.5350/90
1 month 15/18
2 month 30/35
3 months 80/85
London on Frankfurt Rates

Spot 1.8260/90
1 month 60/55
2 month 95/90
3 month 145/140
At which centre, will be investment be made & what will be the net gain (to the nearest pound) to the
bank on the invested funds?
(Answer Hint : (i) If investment is made at London = £ 1,662 (ii) If investment is made at New York
=£ 3,231 (iii) If investment is made at Frankfurt = £ 2,047)

7
INTEREST RATE MANAGEMENT

Marks distribution

7
10.1 Interest rate management basics

1. Interest rate changes can have impact on borrower as well as lender in various ways.
2. For example if an entity is planning to borrow money after 6 months for a period of 3 months.
Interest for such borrowings will not be available today. After 6 months if interest rate increase,
entity ends paying higher interest at the end of 3 months i.e at the time of repayment. On the other
hand, if interest falls after 6 months, then entity will pay lesser interest.
3. To manage interest rate risk various alternatives are available
a. Forward rate agreement
b. Interest rate futures
c. Interest rate options
d. Interest rate guarantee
e. Interest rate collar
f. Interest rate swaps

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10.2 Forward rate agreements

1. A Forward Rate Agreement (FRA) is an agreement between two parties through which a
borrower/ lender protects itself from the unfavourable changes to the interest rate. It is an
agreement where rate of interest is specified for borrowing that takes places after certain period
2. Unlike futures FRAs are not traded on an exchange thus are called OTC product.
3. Reference rate like MIBOR,LIBOR will form the basis for settlement. Rate at which banks are
lend to each other.
4. Quotation Under FRA is expressed as “a X b” where a represents fixing date and b represents
maturity date both starting from today. 6X9 means 6 is fixing date (6 months from today) and 9
is maturity period(9months from today). Borrowing will happen after 6 months and repayment
will be after 9 months i.e term of loans will be 3 months.
5. Settlement amount is fixed on fixing date but settlement on maturity date
6. Settlement can be on delivery or on net basis.
7. When settlement is on net basis computation of amount is as follows
= Notional Principal * (Reference rate – Forward rate)* term of loan
(1+ RR*term loan)
Reference rate : It is the rate of interest published periodically by central bank such as
MIBOR, LIBOR etc.
MIBOR: Mumbai Inter Bank Offer Rate
8. When RR increase, Borrower gains and when RR decrease borrower will loose
9. Borrower will buy FRA(contract to receive ) and Lender will sell FRA(contract to pay)
10. Arbitrage in FRA
a. Arbitrage opportunity exist when theoretical FR (Computed using YTM) is different from
Actual FR.
b. If Actual FR is higher, then strategy should be borrow in theoretical FR and deposit at
actual FR and vice versa.

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10.3 Interest rate futures

1. Meaning
a. An interest rate future is a financial derivative (a futures contract) with an interest-bearing
instrument as the underlying asset.
b. IRF are future contracts will have similar features of Future of share prices like Standard
product, Minimum lot size, expiry period, net settlement.
c. IRF has underlying asset of Interest rates.
2. IRF Prices
a. For trading convenience, interest rates are converted into Prices.
b. When question is silent on prices, use the formula 100- rate of interest.
c. When interest increases, price of IRF will decrease and vice versa.
3. Settlement in IRF
a. In general, to compute interest amount we require principal amount and term of loan
along with rate of interest.
b. In IRF difference between the prices will only provide rate of interest. But other two
factors term of loan principal amount is provided by term of IRF and contract size.
c. Hence to determine overall profit or loss in IRF transaction, factors to be considered are
Price of IRF at entry, Price of IRF at exit, Contract size and term of the IRF.
4. Example,
a. Mr.X entered into 10 contracts of 3 months IRF on 1.3.2018 when interest rates were
8% and squared off his position on 3.3.2018 when interest rates changed to 8.25%.
Assume one contract = Rs.50,00,000. Compute profit or loss made my Mr.X
i. Purchase price = 100 – 8 = 92
ii. Selling price = 100 – 8.25 = 91.75
iii. Loss= 0.25%,Loss (Rs) = 50,00,000*0.25%*3/12*10 = Rs.31,250
b. Observation:, Holding period of 2 days didn’t have any impact on loss computation.
5. Strategy using IRF
a. For borrower
i. A borrower needs protection in case of increase in interest rates. Hence to make
profit in downward market, short position to be taken.
ii. Strategy for borrower is as follows.
1. Today : Enter into IRF Sell (Short position)
2. Later : Square off by IRF Buy.
3. This will result in profit if interest rate increased.
iii. Borrower has to choose IRF depending on his borrowing period and not the term
after which borrowing is made. For example, if intension is to borrow after 4
months for a period of 3 months and if two IRFs are available which are 3 months
IRF and 6 months IRF, then borrower can either choose one contract of 3 months
IRF or 0.5 contract of 6 months . In either cases interest is protected for a period
of 3 months(borrowing period)
b. Summary of strategy
i. A borrower if expects increase in interest rate future
1. Enter intro sell IRF today
2. Buy IRF at a lower price after few months
ii. A lender if expects decrease in interest rate future
1. Enter intro Buy IRF today
2. Sell IRF at a higher price after few months

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10.4 Interest rate Swaps

1. Meaning
a. A swap is a contractual agreement between two parties to exchange, or "swap," future
payment streams based on differences in the returns to different securities or changes in
the price of some underlying item.
b. Interest rate swaps can be viewed as implicit mutual lending arrangements.
2. Features
a. Total payments are determined by the specified notional principal amount of the swap,
which is never actually exchanged. Interest on repayment dates are not paid at gross,
instead settled on net basis
b. This is similar to a betting
c. The floating rate on a generic swap indexed to the six month LIBOR would, in most
cases, be reset every six months with payment dates following six months later.
d. The convention in the swap market is to quote the fixed interest rate as an All-In-Cost
(AIC), which means that the fixed interest rate is quoted relative to a flat floating-rate
index.
3. Example
a. Basic data
i. If Mr.A Believes in Interest rate going up in future and hence take a bet on Fixed
rate of interest say 8%
ii. If Mr.B Belives in Interest going down in future and hence take a bet on floating
rate of interest say LIBOR.
iii. Hence there is opposite intension between A and B.
b. After 1 year, If interest rate increase to 10%(LIBOR As on this date is 10%)
i. A is at advantage position to the extent of (10-8) 2%
ii. B is at disadvantage position to the extent of 8-10% = 2%
iii. B will pay A = 2%
iv. In other words, It is similar to A taking loan from B at 8% interest rate and B
taking loan from A at interest rate of floating rate.
v. A has to pay fixed rate interest which is 8%
vi. B has to Pay Floating rate which is 10%
vii. On net basis A will collect 2%
4. Parties to interest rate swap
a. In every Interest rate swap agreement, two parties are involved. One is called as Fixed
rate payer. And another is floating rate payer.
b. From fixed payer point of view agreement of swap is called as “Pay fixed, receive
floating “ and from floating rate payer point of view it is “ Pay floating and receive fixed
“
c. When interest rate goes up, Fixed rate payer is at advantage and hence floating rate payer
ends up paying fixed rate payer.
d. On other hand, when interest rate comes down, floating rate payer is at advantage and
hence fixed rate payer ends up paying floating rate payer
5. IRS as a tool for Hedging
a. Analysis

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i. Interest rate Swap agreements can be used for existing fixed rate obligations into
floating rate obligations or vice versa for both assets and liabilities i.e for
borrower and for investor.
ii. To convert Fixed rate obligation into floating rate
iii. You have to nullify fixed rate payment.
iv. This needs to be received in Swap.
v. And you need to pay floating rate.
vi. Hence, enter into “Receive Fixed and Pay Floating” interest rate swap.
vii. To Convert floating rate obligation into fixed rate,
viii. enter into “Receive Floating and Pay fixed” interest rate Swap
b. Example
i. If a company has present obligation of LIBOR + 1%
ii. It should enter into “Receive LIBOR and Pay 8%,
iii. Impact of above swap
Case LIBOR Existing Obligation Under SWAP Total
1 7% 7+1 = 8% Receive 7, Pay 8, Net pay 1 8+1=9%
2 10% 10+1 = 11% Receive 10, Pay 8, Net receive 2 11-2=9%
6. Interest rate Swap for Arbitrage Gain

a. Arbitrage gain arises because of disparity in risk premium charged by a bank in case of
fixed rate loan and floating rate loan across two companies having different credit risk.
b. Such disparity can be converted into gain if appropriate strategy is made with swap
arrangements between those companies and borrowing from bank.
c. Steps in Determining swapping strategy to get arbitrage Gain
i. Step 1 : Compute Swapping Gain = Fixed rate premium – Floating rate premium
ii. Step 2 : Allocate the above gain among parties of arrangement including dealer
share if any.
iii. Step 3 : List out the transactions to be carried out
1. A with bank
2. B with Bank
3. Swapping among A and B
iv. Step 4 : Identify type of interest rate for transactions listed in step 3
1. Start from company having relative advantage. If it has advantage in
floating rate, then
2. This company will go for floating with bank
3. In swapping agreement, “ Receive Floating and Pay Fixed “
4. Another company will go for fixed rate with bank
v. Step 5 : Determine the effective interest rates for each of transactions above.
1. If dealer is not there, if B position is determined, A position will be
residual.
2. If dealer is existing, then determine A and B position, dealer position will
be residual.

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10.5 Interest rate options

1. Interest rate caps
a. Meaning : The buyer of an interest rate cap pays the seller a premium in return for the
right to receive the difference in the interest cost on some notional principal amount any
time a specified index of market interest rates rises above a stipulated "cap rate."
b. A call option on reference rate like LIBOR etc is right to buy (receive) reference rate
2. Interest Rate Floors

a. It is an OTC instrument that protects the buyer of the floor from losses arising from a
decrease in interest rates. The seller of the floor compensates the buyer with a pay off
when the interest rate falls below the floors strike rate
b. A put option on reference rate like LIBOR etc is right to sell (pay) reference rate
3. Interest Rate Collars

a. The buyer of an interest rate collar purchases an interest rate cap while selling a floor
indexed to the same interest rate.
b. Borrowers with variable-rate loans buy collars to limit effective borrowing rates to a
range of interest rates between some maximum, determined by the cap rate, and a
minimum, which is fixed by the floor strike price; hence, the term "collar
4. Swaptions
a. An interest rate swaption is simply an option on an interest rate swap. It gives the holder
the right but not the obligation to enter into an interest rate swap at a specific date in the
future, at a particular fixed rate and for a specified term. For an up-front fee (premium)

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10.6 Summary chart
Interest rate management basics
Interest rate
management
Interest rate Interbank

Meaning Instruments
risk offer rate
Managing
Forward Rate
interest rate Borrower Investor Market rate
Agreements
risk
Determined
Risk of Risk of
Current Interest rate by supply and
increase in Decrease in
position futures demand of
interest rates interest rates
money
Prospective Interest rate Used as

position options reference rate
Interest rate Used for

swaps floting rate

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Forward rate agreements
Forward rate
agreement
Meaning Quotations Settlement Purpose
Agreement
Delivery
entered axb Speculation Hedging Arbitrage
basis
today
a: borrowing
Borrowing
Borrowing from Borrowing+
Net basis Only FRA ,investing,
at later date today(fixing FRA
FRA
date)
b : repayment from
Interest rate today(maturity date)
agreed today
Notional Principal * (Reference rate – Forward rate)* term of loan

(1+ RR*term loan)

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Interest rate futures
Interest rate
futures
Meaning Features Hedging
Derivative Borrower-
Standard Special Pricing
with Short on IRF
U/A is rate of Settlement Expressed as Investor-Long

Lot size
interest amount bond price on FRA
Theoretical
Expiry date Sale price price = 100-
rate of interest
- Purchase
Net settlement
price
MTM X lot size
X term of
contract

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Interest rate caps, floors
Derivative with
Meaning
U/A is rate of interest
Premium at the
beginning on reset
periods
Strike rate agreed
Features
Option lying with
Holder
Writer should oblige

Interest rate options
A call option on
reference rate like
LIBOR etc
Interest rate cap
Right to buy (receive )
reference rate
A put option on
reference rate like
Types LIBOR etc
Interest rate floor
Right to sell (pay )
reference rate
It’s a strategy on
Interest rate collar buying cap and selling
floor
Borrower Interest rate cap
Hedging
Investor Interest rate floor

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Interest rate Swaps
IRS
Meaning Purpose
Mutual
Lending Speculation Hedging Arbitrage
contract of
fixed and
floating
Relative
If interest
If interest advantage
Notional rate comes Borrower Investor
rate rises in risk
exchange of down
premium
principal
Floating fixed rate

Share the
rate payer payer to Fixed to Fixed to
swapping
Settled on to fixed rate Floating Floating Floating
gain
Net payer rate payer
Swap
Floating to Floating to agreement
Fixed rate fixed fixed and loans
payer from banks
Floating
rate payer

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Swap gain =
Sharing between
Swap Gain Difference interet
parties
rate differentials
Entity which is Cheaper interest

Relative advantage
paying high interest rate risk premium
Arbitrage steps in
IRS
Entity with relative

with Bank
advantage
opposite type with

Interest rates Other entity
Bank
with opposite
Swapping among
transactions with
entities
Bank

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10.7 Problems
Problem No 1. Hedging in FRA May 2013(8 Marks),RTP November 2018, MTP May 2018,
Parker & Co. is contemplating to borrow an amount of Rs 60 crores for a period of 3 months in the
coming 6 month's time from now. The current rate of interest is 9% p.a., but it may go up in 6
month’s time. The company wants to hedge itself against the likely increase in interest rate. The
Company's Bankers quoted an FRA (Forward Rate Agreement) at 9.30% p.a. What will be the effect
of FRA and actual rate of interest cost to the company, if the actual rate of interest after 6 months
happens to be
(i) 9.60% p.a. and
(ii) 8.80% p.a.?
(Answer hint : If actual rate of interest after 6 months happens to be 9.60% : Rs 4,39,453, If actual
rate of interest after 6 months happens to be 8.80%: Rs 7,33,855)
Problem No 2. Arbitrage in Swaps
Lockwood Company has a high credit rating. It can borrow at a fixed rate of 10% or at a variable
interest rate of LIBOR + 0.3%. It would like to borrow at a variable rate. Thomas Company has a
lower credit rating. It can borrow at a fixed rate of 11% or at a variable rate of LIBOR + 0.5%. It
would like to borrow at a fixed rate. Using the principle of comparative advantage.
Explain how both parties could benefit from a swap arrangement
(Answer Hint :Lockwood L-0.1, Thomas 10.6 )
Problem No 3. Money market operation January( 2021O)(5 Marks)
Bank A enters into a Repo for 21 days with Bank B in 8% Government of India Bonds 2020 @ 6.10%
for Rs 5 crore. Assuming that clean price is Rs 97.30 and initial margin is 1.50% and days of accrued
interest are 240 days (assume 360 days in a year).
Compute:
(i) the dirty price.
(ii) The repayment at maturity.
Problem No 4. Hedging with caps November 2017(8 Marks), MTP November 2021
A textile manufacturer has taken floating interest rate loan of Rs 40,00,000 on 1st April, 2012. The
rate of interest at the inception of loan is 8.5% p.a. interest is to be paid every year on 31st March, and
the duration of loan is four years.
In the month of October 2012, the Central bank of the country releases following projections about
the interest rates likely to prevail in future.
(i) On 31st March, 2013, at 8.75%; on 31st March, 2014 at 10% on 31st March, 201? At 10.5% and
on 31st March, 2016 at 7.75%. Show how this borrowing can hedge the risk arising out of expected
rise in the rate of interest when he wants to peg his interest cost at 8.50% p.a.

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(ii) Assume that the premium negotiated by both the parties is 0.75% to be paid on 1st, October, 2012
and the actual rate of interest on the respective due dates happens to be as: on 31st March, 2013 at
10.2%; on 31st March, 2014 at 11.5%; on 31st March, 2015 at 9.25%; on 31st March, 2016 at 9.0%
and 8.25%.
Show how the settlement will be executed on the perspective interest due dates.
(Answer Hint : On 31st March 2013 68000, On 31st March 2014 120000, On 31st March 2015 30,000
On 31st March 2016 not receive the compensation )

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MERGERS
Marks distribution

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11.1 Basics of mergers

1. Meaning
a. Combining of two or more companies into one company
b. Merger means unification of two entities into one, acquisition involves one entity buying
out another and absorbing the same. In India, in legal sense merger is known as
‘Amalgamation’.
c. Reconstruction
d. Reconstruction involves the winding-up of an existing company and transfer of its asset
and liabilities to a new company formed to take the place of the existing company
2. Reasons and Rationale for Mergers and Acquisitions
a. Synergistic operating economies;
b. Diversification;
c. Elimination of competition
d. Taxation;
e. Growth;
f. Consolidation of production capacities and increasing market power
g. Technical advancement
3. Why mergers fail
a. Cultural differences
b. Flawed intention
c. Insufficient investigation
d. Lack of synergy effect
e. Legal limitations
4. Due diligence
a. Due diligence means research. Its purpose in M&A is to support the valuation process,
arm negotiators, test the accuracy of representations and warranties contained in the
merger agreement, fulfill disclosure requirements to investors, and inform the planners of
post-merger integration.
b. A due diligence process should focus at least on the following issues:
i. Legal issues;,
ii. Financial and tax issues;
iii. Marketing issues;
iv. Cross-border issues; and
v. Cultural and ethical issues.
5. Types of Mergers
a. Horizontal Merger: The two companies which have merged are in the same industry
b. Vertical Merger: This merger happens when two companies that have ‘buyer seller’
relationship
c. Conglomerate Mergers: Such mergers involve firms engaged in unrelated type of
business operations.
d. Reverse Merger A reverse takeover or reverse merger takeover (reverse IPO) is the
acquisition of a public company by a private company so that the private company can
bypass the lengthy and complex process of going public.

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11.2 Basic Formulas

1. Valuation
a. Value based on PE : MPS = EPS*PE
b. Value based on Dividend discount model: MPS = D1
k-g
2. Synergy
a. In earnings = Increase in earnings or savings in expenses
= Earnings of Merged – (Earnings of Acquiring+Earnings of Target )
b. In Valuation , Value of combined entity – (Value of Acquirer + Value of target)
3. Benefits of mergers
a. For acquiring entity
Value of acquisition = Value of merged entity – Value of independent entity
(After merger) (Before merger)
b. For Acquiring company shareholders
Proportionate holding in merged entity - Value of independent entity
c. For Target company shareholders
Benefits = Proportionate holding in merged entity - Value of independent entity
4. SWAP ratio or Exchange ratio
a. Meaning: Ratio of No of shares issued by acquirer for every share held in target company
b. Calculation
i. When ratio is favourable= Target company ratio
Acquiring company ratio
ii. When ratio is unfavourable= Acquiring company ratio
Target company ratio
c. No of shares to be issued by acquiring company = no of shares in target company * Swap
ratio

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11.3 Summary chart
Mergers
Meaning Types Synergy benefits
Earnings of merged
Acquisitions Vertical
entity
Restructuring Horizontal
– Sum of earnings of
entities before merger
Conglomerate
Reverse
Valuation
Based on
Based PE ratio Based on DCF
dividend discount
model
PV of CF
Value of Value = D1/K-g
company = Net
profit * PE ratio
+ PV of TV

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Swap ratio
Meaning Computation
For Favorable For Unfavorable

Ratio of No of To maintain
variables(Better variables(Better
shares issued by EPS
ratio is high) ratio is less)
acquirer
for every share Target Acquiring Swap ratio

held in target Acquiring Target based on EPS
company
Eg,EPS basis,
MPS basis etc
Benefits
Overall/ Benefit of
For Acquirer For shareholders
acquisition
=Value of merged Value of merged Proportionate

entity- entity holding in Merged
entity
Sum of value of -Value of

Independent entities independent - Value of
independent
entity(Before
merger)
- Premium paid

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11.4 Problems
Problem No 1. Merger with PE ratio RTP May 2018,MTP November 2014
The following information is provided related to the acquiring Firm Mark Limited and the target Firm
Mask Limited:
Mark Limited Mask Limited

Earning after tax (Rs) 2,000 lakhs 400 lakhs
Number of shares outstanding 200 lakhs 100 lakhs
P/E ratio (times) 10 5
Required:
(i) What is the Swap Ratio based on current market prices?
(ii) What is the EPS of Mark Limited after acquisition?
(iii) What is the expected market price per share of Mark Limited after acquisition, assuming P/E ratio
of Mark Limited remains unchanged?
(iv) Determine the market value of the merged firm.
(v) Calculate gain/loss for shareholders of the two independent companies after acquisition.
(Answer Hint :(i) 0.20 : 1 (ii) 10.91 (iii) 109.1 (iv) 24002 (v) 1820,182 )
Problem No 2. Merger with PE ratio November 2009(10 Marks), MTP November 2016
You have been provided the following Financial data of two companies:
Krishna Ltd. Rama Ltd.

Earnings after taxes Rs. 7,00,000 Rs. 10,00,000
Equity shares (outstanding) Rs. 2,00,000 Rs. 4,00,000
EPS 3.5 2.5
P/E ratio 10 times 14 times
Market price per share Rs. 35 Rs. 35
Company Rama Ltd. is acquiring the company Krishna Ltd., exchanging its shares on a one-to-one
basis for company Krishna Ltd. The exchange ratio is based on the market prices of the shares of the
two companies.
Required:
(i) What will be the EPS subsequent to merger?
(ii) What is the change in EPS for the shareholders of companies Rama Ltd. and Krishna Ltd.?
(iii) Determine the market value of the post-merger firm. PE ratio is likely to remain the same.
(iv) Ascertain the profits accruing to shareholders of both the companies.
(Answer Hint :(i) New EPS (Rs. 17,00,000/6,00,000) Rs. 2.83, (ii) Increase in EPS of Rama Ltd (Rs.
2.83 – Rs. 2.50), Decrease in EPS of Krishna Ltd. (Rs. 3.50 – Rs. 2.83) Rs. 0.67, (iii) Total market
Capitalization (6,00,000 × Rs. 39.62) Rs. 2,37,72,000 (iv) Gain to share holders 18,48,000, 9,24,000)
Problem No 3. Maximum price computation MTP May 2016,RTP November 2017

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Teer Ltd. is considering acquisition of Nishana Ltd. CFO of Teer Ltd. is of opinion that Nishana Ltd.
ill be able to generate operating cash flows (after deducting necessary capital expenditure) of Rs 10
crore per annum for 5 years.
The following additional information was not considered in the above estimations.
(i) Office premises of Nishana Ltd. can be disposed of and its staff can be relocated in Teer Ltd.’s
office not impacting the operating cash flows of either businesses. However, this action will generate
an immediate capital gain of Rs 20 crore.
(ii) Synergy Gain of Rs 2 crore per annum is expected to be accrued from the proposed acquisition.
(iii) Nishana Ltd. has outstanding Debentures having a market value of Rs 15 crore. It has no other
debts.
(iv) It is also estimated that after 5 years if necessary, Nishana Ltd. can also be disposed of for an
amount equal to five times its operating annual cash flow.
Calculate the maximum price to be paid for Nishana Ltd. if cost of capital of Teer Ltd. is 20%. Ignore
any type of taxation.
(Answer Hint : 60.984 crore. )
Problem No 4. Merger Valuation based on present value

November 2012(8 Marks), MTP May 2014,RTP November 2014,RTP November 2018, MTP
November 2017
Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the merged entity are given
below:
(Rs In lakhs)
Year 1 2 3 4 5
Yes Ltd. 175 200 320 340 350
Merged Entity 400 450 525 590 620
Earnings would have witnessed 5% constant growth rate without merger and 6% with merger on
account of economies of operations after 5 years in each case. The cost of capital is 15%.
The number of shares outstanding in both the companies before the merger is the same and the
companies agree to an exchange ratio of 0.5 shares of Yes Ltd. for each share of No Ltd.
PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497 respectively.

(i) Compute the Value of Yes Ltd. before and after merger.
(ii) Value of Acquisition and
(iii) Gain to shareholders of Yes Ltd.
(Answer Hint : (i) Value of Yes Ltd. = Before merger (Rslakhs) =2708.915, After merger (Rslakhs) =
5308.47 (ii) Value of Acquisition= Rs2599.555 lakhs) (iii) Gain to Shareholders of Yes Ltd=
Rs830.065 lakhs)
Problem No 5. Merger based on dividend-based valuation

MTP May 2013,RTP November 2013,RTP May 2015, MTP November 2017

7
Hanky Ltd. and Shanky Ltd. operate in the same field, manufacturing newly born babies’s clothes.
Although Shanky Ltd. also has interest in communication equipments, Hanky Ltd. is planning to take
over Shanky Ltd. and the shareholders of Shanky Ltd. do not regard it as a hostile bid.
The following information is available about the two companies
Hanky Ltd. Shanky Ltd.

Current earnings Rs 6,50,00,000 Rs 2,40,00,000
Number of shares 50,00,000 15,00,000
Percentage of retained earnings 20% 80%
Return on new investment 15% 15%
Return required by equity shareholders 21% 24%
Dividends have just been paid and the retained earnings have already been reinvested in new projects.
Hanky Ltd. plans to adopt a policy of retaining 35% of earnings after the takeover and expects to
achieve a 17% return on new investment. Saving due to economies of scale are expected to be Rs
85,00,000 per annum.
Required return to equity shareholders will fall to 20% due to portfolio effects.
Requirements
(i) Calculate the existing share prices of Hanky Ltd. and Shanky Ltd.
(ii) Find the value of Hanky Ltd. after the takeover
(iii) Advise Hanky Ltd. on the maximum amount it should pay for Shanky Ltd.
(Answer Hint : (i) Market price 59.51, 29.87 (ii) = 47,34,12,811 (iii) ) 17,58,57,255
Problem No 6. Weighted average swap ratio May 2011(8 Marks)
Abhiman Ltd. is a subsidiary of Janam Ltd. and is acquiring Swabhiman Ltd. which is also a
subsidiary of Janam Ltd. The following information is given :
Abhiman Ltd. Swabhiman Ltd.

% Shareholding of promoter 50% 60%
Share capital Rs 200 lacs 100 lacs
Free Reserves and surplus Rs 900 lacs 600 lacs
Paid up value per share Rs 100 10
Free float market capitalization Rs 500 lacs 156 lacs
P/E Ratio (times) 10 4
Janam Ltd., is interested in doing justice to both companies. The following parameters have been
assigned by the Board of Janam Ltd., for determining the swap ratio:
Book value 25%,Earning per share 50%,Market price 25%
You are required to compute

(i) The swap ratio.
(ii) The Book Value, Earning Per Share and Expected Market Price of abhiman Ltd.,(assuming P/E
Ratio of Abhiman ratio remains the same and all assets and liabilities of Swabhiman Ltd. are
taken over at book value.)

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(Answer Hint : (i) SWAP Ratio is 0.148825 (ii) Book value =516.02, EPS =56.62, Expected market
price =566.20)
Problem No 7. Merger with proxy beta May 2010(O)(8 Marks)
ABC, a large business house is planning to sell its wholly owned subsidiary KLM. Another large
business entity XYZ has expressed its interest in making a bid for KLM. XYZ expects that after
acquisition the annual earning of KLM will increase by 10%. Following information, ignoring any
potential synergistic benefits arising out of possible acquisitions, are available:
(i) Profit after tax for KLM for the financial year which has just ended is estimated to be Rs. 10 crore.
(ii) KLM's after tax profit has an increasing trend of 7% each year and the same is expected to
continue.
(iii) Estimated post tax market return is 10% and risk free rate is 4%. These rates are expected to
continue.
(iv) Corporate tax rate is 30%.
XYZ ABC Proxy entity for KLM in the same line of

business
No. of shares 100 80 --
lakhs lakhs
Current share price Rs. 287 Rs. 375 --
Dividend pay out 40% 50% 50%
Debt : Equity at market 1:2 1:3 1:4
values
P/E ratio 10 13 12
Equity beta 1 1. 1 1.1
Assume gearing level of KLM to be the same as for ABC and a debt beta of zero.
(i) Appropriate cost of equity for KLM based on the data available for the proxy entity.
(ii) A range of values for KLM both before and after any potential synergistic benefits to XYZ of the
acquisition
(Answer Hint :(i) 10.93%,(ii) Rs. 100 Crore to Rs. 149.75 Crore)
Problem No 8. Levered buyout May 2016(8 Marks),RTP November 2018
The CEO of a company thinks that shareholders always look for EPS. Therefore he considers
maximization of EPS as his company's objective. His company's current Net Profits are Rs 80.00
lakhs and P/E multiple is 10.5. He wants to buy another firm which has current income of Rs 15.75
lakhs & P/E multiple of 10.
(i) What is the maximum exchange ratio which the CEO should offer so that he could keep EPS at the
current level, given that the current market price of both the acquirer and the target company are
Rs 42 and Rs 105 respectively?
(ii) If the CEO borrows funds at 15% and buys out Target Company by paying cash, how much
should he offer to maintain his EPS? Assume tax rate of 30%.
(Answer Hint : for every one share of Target Company 2.625 shares of Acquirer Company, Rs 150
lakhs shall be offered in cash to Target Company to maintain same EPS.)

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Problem No 9. Bank merger May 2017(10 Marks)
XML bank was established in 2001 and doing banking business in India. T he bank is facing very
critical situation. There are problems of Gross NPA (Non -Performing Assets) at 40% & CAR/CRAR
(Capital Adequacy Ratio/Capital Risk Weight Asset Ratio) at 2%. The net worth of the bank is not
good. Shares are not traded regularly. La st week, it was traded @Rs 4 per share. RBI Audit suggested
that bank has either to liquidate or to merge with other bank.
ZML Bank is professionally managed bank with low gross NPA of 5%. It has net NPA as 0% and
CAR at 16%. Its share is quoted in the market @ Rs 64 per share. The Board of Directors of ZML
Bank has submitted a proposal to RBI for takeover of bank XML on the basis of share exchange
ratio.
The Balance Sheet details of both the banks are as follows:
PARTICULARS XML Bank (Rs) (Amount in ZML Bank (Rs) (Amount in

Crores) Crores)
Liabilities
Paid up share capital (Rs 70 250
10)
Reserve and Surplus 35 2,750
Deposits 2,000 20,000
Other Liabilities 445 1,250
Total Liabilities 2,550 24,250
Assets
Cash in hand and with RBI 200 1,250
Balance with other banks 0 1,000
Investments 550 7,500
Advances 1,750 13,500
Other Assets 50 1,000
Total Assets 2,550 24,250
It was decided to issue shares at Book Value of ZML Bank to the shareholders of XML Bank All
Assets & Liabilities are to be taken over at Book Value. For the Swap Ratio, weights assigned to
different parameters are as follows:
Gross NPA 40%

CAR 10%
Market Price 40%
Book Value 10%
You are required to :

(i) Calculate swap ratio based on above rates.
(ii) Calculate number of shares are to be issued.
(iii) Prepare Balance Sheet after Merger.
(iv) Compute CAR and Gross NPA after merger

7
(Answer Hint : (a) Swap Ratio every share of Bank XML 0.1 share of Bank ZML shall be issued. (b)
No. of equity shares to be issued = 70 lakh (c) Balance Sheet total after Merger 26800.0 crs)

Chinmay Hegde SFM Class Notes

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CA FINAL

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

Chapterwise marks distrubution

Attempts before May 2018 were Old syllabus

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

8.1 Basic terminologies ................................................................................................................... 161

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

FINANCIAL POLICY AND CORPORATE

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

1.1 Foundation principles

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

1.2 Strategies and Framework

2. Strategy at Different Hierarchy Levels

3. Basic Issues Addressed Under Financial Planning

4. Interface of Financial Policy and Strategic Management

5. Balancing Financial Goals Vis-a-Vis Sustainable Growth

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

1.3 Formula basics

2. Compounding more than once a year

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

Compounding frequency Formula

e will reflect 1+r

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

1.4 Summary chart

Average Cost Benefit Zero position

Market factors Subjective

Compounding interest Present value

F=P(1+r)n One time CF Consistent CF Installment

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

Finding present value

• Year• Cash flow• Discounting factor• Discounted cash flow

• • • • Total Present value

Compounding more than once a year

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

Expected value under probability

E(x) = Σpx where p is probability and x is random variable

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

Type of repayment Interest payment, principal repayment

2.2 Valuation of bonds

2. Value of different types of bonds based on repayment

Coupon = Face value * Coupon rate

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

2.3 Yield to maturity YTM

Coupon = Face value * Coupon rate

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

2.4 Duration (Macaulay duration)

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

2.5 Volatility of bond or modified duration

CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

2.7 Problems on Duration and volatility

Problem No 1. Duration and volatility

The following data are available for a bond

(Answer Hint : 4.09 years, 3.75 times ,Rs = 1108.28 )

Problem No 2. Impact of change in YTM

The following data are available for a bond

(Answer Hint : 964.24, 4.24 years, 3.6258 times, Rs 938.14)

Problem No 3. Change in YTM (June 2009) (8Marks)